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A CURE FOR THE REAL ESTATE BLUES
A real estate veteran sees a rare opportunity to buy quality REITs at fire-sale prices.
Stocks selling at hefty discounts to depressed valuations are the prime ingredients of bargains. This is the case currently for real estate investment trusts. Real estate constitutes a fair percentage of the world’s financial assets, so any true market index would have to include some real estate investments. REITs are much the most convenient way to gain exposure to real estate for the average investor. Real estate veteran Marty Cohen suggests you choose your exposure carefully, and has some suggestions.
When we talked with real estate veteran Marty Cohen two years ago, the good times were rolling for real estate investment trusts, or REITs, which invest in commercial, industrial and consumer properties and pay out nearly all of their taxable income as dividends.
Then, last year, the bottom fell out. Property values sank as the subprime-mortgage crisis mushroomed, and REIT stocks plummeted, with many now trading 60% below their former highs. When might the industry recover, and which REITs look most promising now? We put these and other questions to Marty – whose Cohen & Steers manages mutual funds that invest in REITs worldwide – in a recent follow-up interview. For a pro’s answers, read on.
Barron’s: What a difference two years makes. What happened to seemingly rock-solid REITs?
Cohen: The record decline in prices happened in two waves. In early 2007, most REITs were trading in line with their net asset values. Those values reflected the plentiful and low-cost capital that had been offered to real estate investors, that resulted in a massive privatization wave of REITs. About $200 billion of takeovers occurred in the prior two years.
When credit began to constrict, demand for real estate and public REITs disappeared. For a while REIT prices stabilized, but by fall, it appeared that the economy was falling off a cliff and the financial system was collapsing. The second down-wave was steep and swift. Without credit, and with great uncertainty about the future of occupancies and rents, real estate and REITs became impossible to value.
What is the immediate outlook? How long will it take to stop the bleeding?
REITs are trading at steep discounts to asset values, even using reduced estimates of value.
Property transactions have come to nearly a complete halt. The market has discounted REIT shares to levels that anticipate a drawn-out period of deteriorating fundamentals. They are trading at steep discounts to asset values, even using our reduced estimates of value, historically high dividend yields and low price-to-cash-flow multiples. The single most important factor affecting a recovery will be the course of the economy. Fortunately, in this cycle there has not been a great deal of overbuilding, which would have worsened the outlook considerably, as it did in the early 1990s. We expect the record fiscal and monetary stimulation being put in place worldwide to at least stem the economy’s decline. We should start seeing evidence of this by the end of 2009, when economic statistics begin to suggest a bottom. REITs tend to be early-cycle stocks, so they could start to perform well sometime between now and then. Meantime, it is hard to imagine valuations getting much worse.
So the worst is over?
It is likely things will get a bit worse before they get better. When you are going through a recession, sentiment is always bad, and things always seem worst near the bottom. The “it is never coming back” chorus is getting louder. On the other hand, there has never been more fiscal and monetary stimulus thrown at the world’s economies. Mortgage rates are down. Mortgage refinancing is up. Spreads are starting to narrow between different grades of securities. But it is going to take time because the economic and financial crisis is just too big.
How has all of this affected your business?
Our assets under management have declined considerably. But because of our strong financial position – no debt and lots of cash – we have seen no reason to retrench or reduce our commitment to the sector. On the contrary, this is an extraordinary opportunity to gain market share and to participate in an industry recovery.
The one fact of life that we need to reconcile is the extreme volatility REIT shares have experienced. Daily moves of 5% to 10% or more have become routine. Much of this volatility is due to industry participants using options, ETFs [exchange-traded funds] and other derivatives – and in a market that is less liquid than many other industries. Once confidence is restored, a strong bid will appear that will dampen downside volatility.
Have you had many redemptions?
There have been modest, if any, redemptions from mutual funds, and almost no loss of institutional assets. The decline in assets primarily has been the result of asset depreciation. The client or two that we may have lost was obligated to fund another commitment or just needed cash.
Has demand finally caught up with supply in the office market?
Supply and demand were in pretty good balance until recently. Vacancy rates in the New York office market and elsewhere have begun rising at alarming levels. We do not have the major overbuilding that occurred in other cycles, which is positive. You will not see new construction for a long while because builders cannot get financing. And in this economy, even if they could get it, landlords would not be able to get the rents to justify new space. If there is vacant space that can be leased at $80 a square foot, why would you build a building where you need $120 to break even? Existing owners are operating under a “rent umbrella,” or a gap between market rents and required rents on new buildings. You will not see construction for several years.
You are speaking of office buildings?
Pretty much everything. We have seen mall projects canceled, residential projects suspended and few office buildings even being planned. Again, banks are not lending, and if they do, they are requiring very high cash commitments by owners – which owners are unable or unwilling to provide.
Many REITs have eliminated or cut their dividends. Given that income has always been the main selling point for REITs, what lies ahead in payouts?
Two years ago the REIT industry was trading at a 4% dividend yield. Recently, that yield was 12%, but for the first time ever a lot of dividends are being cut. In the past four months, more than 39 companies have reduced or eliminated their dividends. Some companies have used the dividend-cut strategy as an opportunity to preserve capital. Some boards and CEOs have simply panicked and are doing their shareholders a major disservice by cutting dividends. Investors value real estate for its income. Once you interrupt that stream of dividends, you have impaired investor confidence for a long time.
Won’t REITs be able to retain cash now that an expanded IRS rule allows dividends to be paid in stock?
Payment in stock instead of cash is the single worst idea hatched in the industry in a long time. Under the expanded rule, a REIT may issue up to 80% of its dividend in stock instead of cash to satisfy its dividend-payout requirement. Given a choice, there is no reason any investor would want stock instead of cash. Pay-in-kind dividends and interest are normally associated with companies that cannot pay in cash. Paying PIK dividends sends a damaging signal.
If a company is truly cash-constrained, this could be a viable alternative, and it should be made clear to shareholders. But many companies that are able to maintain dividend payments in cash are choosing stock instead to retain their liquidity. Some others are reducing dividends. This is short-term thinking that will impair the company’s long-term cost of capital.
Will most REIT CEOs take advantage of the switch to stock dividends?
There is a danger that more and more companies will fall prey to this mentality, further alienating their shareholders. Also, bear in mind that taxable investors and mutual funds, which are major holders of REITs, would have to sell the stock they receive in order to satisfy their own tax or distribution requirements. This can create pressure on share prices.
Retailers like Circuit City are liquidating and vacating space in shopping centers. Won’t this hurt REITs further?
The pain will be felt throughout the retail real estate market, which is already hurting. It means more vacant space, and there are too few retailers who need that space. Rents are going to fall as retailers renegotiate their leases to cut costs, and landlords, facing more empty space, are likely to go along with them. It is not a good situation.
It is a bad one, in fact, for investors in commercial mortgage-backed securities, who have already seen prices slide.
The CMBS market came to a grinding halt early last year, and there has been no new issuance since. And there is unlikely to be any new issuance for a long time. Current CMBS pricing is factoring in a very high default rate, even though to date there have been very few defaults. It is possible the market’s worst fears are overblown.
Given the state of things, should investors keep their distance from REITs, or step in while prices are down?
I have never seen REITs cheaper than they are today. The three largest REITs I would recommend are Simon Property Group [SPG], the biggest owner of malls and other retail properties in the country; Boston Properties [BXP], a large owner of Class A offices in New York, Washington, Boston and San Francisco; and AvalonBay Communities [AVB], one of the largest owners of rental apartments in the most vibrant rental markets on the east and west coasts. All three are well capitalized, in the Standard & Poor’s 500, extremely well managed, well positioned from a property standpoint, and with a lot of capital so they are not going to be caught in a liquidity crunch. Here is an illustration: Simon is trading in the mid-40s with a dividend yield of about 8%. Its high was over 100 per share. When the economy turns, retail will start growing again. There is no reason Simon’s share price could not get back to its old high in the next few years. In the meantime, the dividend pays you to wait. Similar metrics apply to Boston and AvalonBay.
What about other REITs?
There is a second group with much greater financial and operating leverage, although there is no guarantee they are going to make it through hard times. But if they do, there is a chance you could make a multiple on your money in REITs such as Macerich [MAC] and Developers Diversified Realty [DDR].
Host Hotels & Resorts [HST] is a leading owner of hotels, a business that is going to be in the doldrums for a while. But the lodging industry is extremely sensitive to changes in the economy and has huge operating leverage. Finally, we really like Brookfield Properties [BPO], a major owner of office buildings, which is suffering from the fallout of the financial industry, particularly since it is heavily exposed to downtown New York. But the company is soundly financed and managed and reasonably diversified, so we see limited downside from here.
Some REITs have issued convertible debt. What is that all about?
There has been a massive market for converts, and a number of REITs issued them in the past couple of years, but I never understood why. They were priced at low yields and big premiums to share prices. It was paper with a put back to the company in year five, and many companies are regretting it now because the put is equivalent to a looming large-debt maturity. The convert market has collapsed along with everything else, and the prices of these converts have tumbled to well below par, with attractive current yields. Some companies are trying to buy them back at a discount. It is another free lunch gone for the companies, but an opportunity for investors.
Give us some examples.
One interesting issuer is SL Green Realty [SLG], a New York REIT that primarily owns office properties in New York City. One of its converts carries a 3% coupon but is trading well below par with a 19% yield to put. Prologis [PLD], a Denver-based REIT that develops and operates the largest portfolio of industrial and distribution properties in the world, has a convert with a 2% coupon and a 21% yield to put. Weingarten Realty Investors [WRI], which invests in shopping centers, has a convert with a 3.95% coupon and an 19% yield to put. All three have about three years remaining until the put is exercisable.
Then there is an unsecured bond we really like, issued by Healthcare Property Investors [HCP] , which carries a 6% coupon. It is a straight bond, but it has six years to go and trades at a 14.3% yield to maturity. So if you do not like the equities, you can get enormous yields on the debt.
What is interesting outside the U.S.?
The best plays are in the U.S. It will be the first to recover, while Europe is only beginning to recognize its problems. But having said that, we found two interesting closed-end funds, aside from our own Cohen & Steers funds, that invest in real estate outside the U.S. One is ING Clarion Global Real Estate Income [IGR], which invests in common and preferred stocks of real estate companies around the world. It is leveraged and owns stocks that are trading at a 20% discount to their NAVs, while the fund itself is trading at a 20% discount to its own NAV. The other, Alpine Global Premier Properties [AWP], is trading at a big discount but it is not leveraged. There probably is a little less risk in a nonleveraged fund, but you still have a big yield. It is a good way to go global.
Marty Cohen’s Picks Company Ticker Price ($) Simon Property Group SPG 44.44 Boston Rroperties BXP 44.26 AvalonBay Communities AVB 54.68 Macerich AC 15.85 Developers Diversified Realty DDR 4.81 Host Hotels & Resorts HST 5.76 Source: Bloomberg
LBO’S GO KA-BOOM!
Many leveraged buyouts are underwater, and likely to stay there for some time. It is time for the buyout kings to fess up to the mess. Coming next: regulation?
The private equity/LBO operators were poster children for the excesses, delusions, and self-serving pontifications that came out of the credit bubble. Somehow overpaying for a company using debt financing, adding still more debt to the financial struction in order to do an “equity extraction,” and then waiting around for a still-greater fool(s) to take the property off one’s hands never struck us as much of a value-adding proposition.
In the early days of the LBO era – late 1970s/early ‘80s – one could argue the LBO boys did help rationalize many business mishmashes left over from the 1960s conglomeration excesses. The buy/rationalize/sell strategy only worked when the targeted assets were underutilized and, importantly, undervalued enough that you could buy the public out at a nice premium and still be getting the assets cheaply. We do not know exactly when during the bull market that started in 1982 those opportunities were sufficiently diminished to rationally support only a boutique LBO industry. The epic battle over the buyout R.J. Reynolds in 1988 indicates there was more money than deals (and sense) available by then.
Thanks to the bull market in credit and suckers the LBO artists did not have to find other lines of work. They just kept doing deals with all the easy money. Now, 20 or so years overdue, the industry and idea has been discredited. There is no more credit to finance deals, or to finance the people that would bail out the initial buyers. The heads of Blackstone Group, KKR, et al will soon have no choice but to admit that they overpaid for most of the buyouts of the last decade. Not that the heads will go hurting. They have long since been playing with “house money.”
The battered private-equity business has yet to acknowledge what many of its investments probably are worth: little or nothing.
Even as industry leaders like Steve Schwarzman of Blackstone Group and Leon Black of Apollo Management talk about the enormous opportunities awaiting them in today’s depressed stock and bond markets, they are saying little about the disastrous investments their firms made at the height of the leveraged-buyout bubble in 2006 and 2007, when hugely inflated prices were paid for companies such as Harrah’s Entertainment and Hilton Hotels – before the economy tanked.
The private-equity business, a leading actor in the roaring bull market of recent years, is facing its biggest crisis ever, now that financing for leveraged buyouts has dried up. Even if credit starts flowing again in 2010 or 2011, it is unclear how much money will be available for LBOs, or whether corporate boards will want anything to do with the likes of Blackstone, Kohlberg Kravis Roberts and Apollo, after buyout firms pulled out of many 2008 deals. Nor does investing in “distressed” debt and equity look like a promising sequel for the buyout kings, who have little history or success in this business – and may bear some responsibility for the distress.
The contention that there is minimal equity value in dozens of LBOs is supported by several factors. Many bonds issued by highly leveraged companies are trading for less than 50 cents on the dollar. In addition, the Standard & Poor’s 500 index is off 40% in the past year, and shares of many publicly traded, debt-laden companies are down much more. Two investment vehicles run by Apollo and Kohlberg Kravis Roberts now trade publicly in Europe for a fraction of the asset values assigned by their managers, indicating that investors are skeptical of the stated investment values. And, when some cash-strapped pension funds and endowments have sought to sell their interests in private-equity funds in private transactions, the going rate has been as low as 20 cents on the dollar.
The financial performance of many LBOs began to sag in the 3rd quarter of 2008, owing to heavy debt and a weakening economy, and the situation is likely to only worsen this year. Boston Consulting Group estimated in a 2008 report that 40 of the top 100 global buyouts could collapse because of defaults on as much as $1 trillion of debt, although the firm didn’t identify likely victims.
Ironically, heavy losses on LBO debt will not be a major problem for banks, because their remaining exposure may be only about $50 billion to $80 billion. Banks, hedge funds and junk-bond mutual funds have taken most of their lumps already, by marking their holdings to market. LBO bank debt now trades for an average of 65 to 70 cents on the dollar, well above more junior public debt.
Nassim Taleb, author of The Black Swan and other books, neatly summed up the sea change in private equity on Bloomberg radio last week. “These people in a bull market looked like geniuses, and now they don’t look that intelligent,” Taleb said. “It is going to get a lot worse for them.” Taleb has long warned of the dangers in financial markets.
Private-equity firms potentially face a wipeout of their investments in a range of companies, including Harrah’s, Clear Channel Communications, Hilton Hotels, Freescale Semiconductor, Realogy, Station Casinos and Claire’s Stores. But it may take time for the crisis to unfold, as debt payments in many deals are not due for several years.
Apollo Management’s record is particularly poor on deals struck in 2006 and 2007 for Harrah’s, Realogy, Claire’s, Jacuzzi Brands, Noranda Aluminum, Verso Paper and a leading British real estate agency. All look to have run into trouble. The New York firm’s investment in Linens ‘n Things is toast, following the retailer’s bankruptcy and recent U.S. liquidation.
The toll from the LBO boom is more than just financial. Burdened with heavy interest costs, companies are laboring to stay competitive against stronger rivals in a difficult economy, increasing the pressure to reduce capital spending and lay off workers. As a public company, Linens ‘n Things was a weaker but viable competitor to Bed Bath & Beyond. Now it’s gone, and so are thousands of jobs. The populist mood in Washington and widespread revulsion toward Wall Street aren’t good news for private equity, either.
Even though private-equity interests are illiquid and meant to be held for years, they are supposed to be priced at “fair value,” much like stocks and bonds, based on accounting rules implemented in recent years. Some private-equity investments have been marked down already; Apollo valued its stake in Harrah’s at 60 cents on the dollar at the end of the third quarter, the most recent date for which detailed valuation information is available. But many private-equity stakes were carried at original cost as recently as September 30, including KKR’s interest in First Data. Others, like the firm’s stake in HCA, were held at a profit.
Blackstone Group, the only major buyout firm that is publicly traded, refuses to disclose the value of its individual investments, including stakes in such evident LBO clunkers as Hilton, Freescale and Michaels Stores. Blackstone’s view is that institutional investors in its private-equity and real estate funds are entitled to critical portfolio information, but not its public shareholders. The company could not be reached for comment.
To the extent that outside auditing firms need to bless private-equity firms’ financial statements, they should have taken a hard look at investment values in year-end audits, given the meltdown in stock and bond markets last year. If the accountants were not up to the job, the new chairman of the SEC, Mary Schapiro, ought to take up the matter, a possibility that may be less remote than it sounds. “Regulation is coming, and it is going to come in a very major way,” KKR co-founder Henry Kravis told an audience last week at the World Economic Forum’s annual meeting in Davos, Switzerland.
Here is some advice for the SEC: Be skeptical of any private-equity investment carried for a higher price than the issuer’s public debt. In some situations, bondholders could end up owning a company after a bankruptcy or restructuring, while equity holders would be wiped out.
What is the right value for many of these equity investments? Most would seem to have little more than “option value” equal to 15% or 20% of the original value, based on the hope that economic and financial conditions improve markedly in the coming years.
Apollo has been trying to salvage its investments by reducing debt at companies like Realogy and Harrah’s. The firm recently completed an exchange offer involving Harrah’s, in which junior bondholders accepted less than face value to get new, more senior debt. These controversial actions, which have angered powerful bondholders like Carl Icahn, are probably going to become more common as buyout shops try to save their equity investments.
Most big LBOs in 2006 and ‘07 involved equity contributions of 25% or less of the total purchase price. This reflected the abundance of credit, and the strategic efforts of many firms to get the most bang for their investment dollars. The high-risk approach brought high returns in the bull market of 2003 to mid-2007, but is backfiring now.
Private-equity firms say they have staying power because many LBOs got both generous financing with no immediate debt maturities and liberal bank loans that creditors can rarely call in. The buyout barons also say prices in the junk market are unduly depressed, and should not be used as benchmarks in valuing the “portfolio companies” they control.
These are fair arguments, but do not excuse the firms from valuing their investments on the basis of current conditions. Traditional asset managers are obligated to mark their stock, bond and other holdings at market prices, regardless of what they might think the investments are worth. To value its investments, Blackstone uses “discounted cash flows” based on multiyear cash-flow projections for the 50 or so companies it controls. To come up with values, it also must estimate what a buyer would pay for the different companies.
Asked on Blackstone’s November conference call about the relevance of comparable public-company valuations in Blackstone’s analysis, Tony James, the firm’s president, did not give a clear answer. “We take public comps [comparables] into account, but often we do not exit into the public market by doing IPOs, so they are sort of irrelevant.”
James added that Blackstone has often sold its companies to other private-equity shops or corporations. Neither option looks feasible in the near term, suggesting public markets are the best guide to value. Blackstone was still carrying its private-equity and real estate funds at a profit on September 30, after modest writedowns in the quarter.
Investor agreements generally entitle private-equity firms to collect base management fees averaging 1.5% a year based on committed capital, not the original cost of investments or their fair value. The clock starts ticking when the fund is launched, even if all the money has not yet been put to work.
The typical buyout fund runs 10 years, with a 6-year period of investment during which the base fee is collected and a subsequent four-year “harvesting” period during which a lower fee is charged. Typically, buyout firms also collect 20% of the gains on their investments, sometimes subject to a pre-determined minimum return “hurdle.” These incentive fees, or “carry,” enriched buyout firms during the boom years earlier in the decade, but there may be little carry income in the next few years.
Longtime relationships with key institutional clients – including endowments and public pension funds – presumably have been frayed as the firms have demanded money pledged for new investments while returning hardly anything from existing ones. This has caused liquidity problems for a number of endowments, which have been forced to sell stocks at fire-sale prices to finance private-equity requests for fresh money. Private-equity firms have been loath to allow their clients to get out of their commitments.
Harvard University, the nation’s largest endowment, with $37 billion of assets on June 30, was rumored recently to be looking to unload some of its private-equity funds. Harvard reportedly sold little because the prices offered were deemed too low.
The valuation issue is not academic, especially for endowments and pensions, which rely on accurate investment values to make key asset-allocation and spending decisions. To the extent that private-equity values are too high, endowments may have too much exposure to that asset class, and spend too much of their funds on university operations.
Some of best disclosure on private-equity valuations comes from Apollo Management and KKR, because those firms manage exchange-traded funds in Europe that invest alongside their private-equity funds and disclose results quarterly. The Apollo and KKR vehicles, as well as Blackstone, have yet to disclose 4th-quarter results.
These funds now trade well below the reported value of their investments. KKR Private Equity Investors was trading last week at $2.30, 88% below its September 30 asset value of $18.85, while Apollo’s AP Alternative Assets fetched $2.40, versus a November 30 asset value of about $10.30 a share. Blackstone’s shares, meanwhile, have fallen to 4.50 from 31 at the time of the firm’s 2007 IPO.
Barron’s has been bearish on Blackstone since it went public, in a cover story (“Top of the Market,” June 25, 2007) and subsequent articles. Although the stock trades for a relatively modest 7.9 times projected 2009 profits, using the firm’s preferred earnings definition that excludes certain noncash expenses, it is tough to get excited because of the potential for large markdowns in its portfolio.
The private-equity landscape is not uniformly bleak. Among potential winners is KKR’s LBO of Dollar General, which has benefited from good management and a focus on lower-income consumers. Dollar’s pretax cash flow rose more than 60% in the quarter ended October 31. Whether KKR makes much money on the deal may depend on the market’s treatment, now brutal, of retailers’ shares.
More common are companies with decent businesses but too much debt. Univision, the formerly hot Spanish-language broadcaster, has been stung by the downturn in advertising, an ominous development in view of its debt load of $10 billion, roughly 12 times annualized cash flow. Univision’s pretax cash flow is barely enough to cover its interest costs. Big media companies have been crushed in the stock market, with companies like Time Warner, Viacom and News Corp. (parent of Barron’s) now valued at less than six times annual pretax cash flow. This suggests that Univision’s equity has little current value, which is reflected in the battered price of the company’s junior public debt: 16 cents on the dollar.
KKR was carrying its interest in HCA (the big hospital company) at a profit at the end of the third quarter. But that looks aggressive because of HCA’s $27 billion of debt, declining earnings and minimal free cash flow. Gimme Credit analyst Vicki Bryan pointed out late last year that debt is virtually the same as when the company went private in 2006, and totals about six times pretax cash flow. That is about equal to the current value of some public hospital stocks, suggesting there may not be much value in HCA equity.
First Data, the financial processor, also carries excessive debt of $22 billion, equal to a stiff 11 times estimated 2008 pretax cash flow, and its revenue growth has slowed. Gimme Credit analyst Dave Novosel has pointed out that the company’s free cash flow likely totaled just $150 million in 2008, compared with $1.8 billion annually when it was a public company. The difference? $2 billion of interest expense.
Hilton is an even more troubled deal. Blackstone bought the company at the top of the hotel market when it agreed to acquire it in mid-2007 for $26 billion. The firm considers Hilton a success, pointing to the 13% growth in the hotel operator’s pretax cash flow in the first nine months of 2008. However, Hilton also has $20 billion of debt, and the lodging market is weakening rapidly. Hilton generated $1.8 billion of pretax cash flow in 2008, leaving debt equal to about 11 times trailing cash flow.
Rival Starwood Hotels & Resorts has seen its share price fall 78%, to 15, since the Hilton deal was inked; Starwood’s equity is valued at less than seven times trailing cash flow. This suggests little or no current value in Blackstone’s $5 billion equity stake in Hilton, its largest investment ever. The situation could worsen this year, when Hilton’s cash flow could drop 15% or more.
Freescale Semiconductor faces difficulty in 2009, owing in part to industry problems and its exposure to the auto market. Standard & Poor’s recently downgraded its debt rating on Freescale to B-minus from B-plus, saying it expects a “negligible” recovery on the company’s unsecured debt in the event of default. Freescale went private in an $18 billion deal, and carries $9 billion of debt. Reflecting the grim outlook, some Freescale debt trades for 20 cents on the dollar.
Clear Channel Communications went private in mid-2008 in a $22 billion deal; the radio and billboard company has been plagued by heavy debt and weak ad markets. Its woes are evident in shares (CCMO) that remain public and now languish at $2, down 90%. The $36-a-share buyout permitted public holders to participate in the LBO by keeping part of their equity. Clear Channel debt trades for as little as 15 cents on the dollar. The buyout group, led by Bain Capital and Thomas H. Lee Partners, should take a big markdown on its equity, if it has not done so already.
Station Casinos, which caters to Las Vegas locals, has been battered by that city’s economic collapse, and its debt now trades as low as 5 cents on the dollar. Claire’s Stores looks like a wipeout for Apollo, which took it private in 2007, as cash flow is not enough to cover interest expense. Its debt trades at just 15 cents on the dollar.
For the sake of their clients and their reputations, it is time for buyout firms to come clean and value their investments at their current worth, which may be little. If the markets and economy improve, they can always be revalued. But many are so far underwater that they may not be worth much when Blackstone, KKR and Apollo get around to executing their “exit strategies.”
VENTURE CAPITAL’S NEW GRAIL: ALREADY SUCCESSFUL COMPANIES
After a stretch of lousy returns Silicon Valley’s VCs are searching for companies with novel traits: rising revenue and profits.
Most venture capitalists have hordes of entrepreneurs clamoring for a few moments of their time. Jonathan Meeks prizes his list of people who do not want to take his calls.
Meeks, then a vice president with TA Associates, first rang Sunil Hirani, cofounder of the New York electronic derivatives broker Creditex, in 2003. The former NASA software guru firmly told Meeks that his 4-year-old firm was profitable, growing and did not need his money. For three years Meeks logged monthly calls to Hirani, quizzing him on the economics of brokerage firms and swapping industry gossip.
When another Creditex cofounder needed to sell his stake, Hirani ushered the deal to Meeks, who bought 50% of the firm for $57 million. Last June, five years after Meeks’ first call, he got his reward: Intercontinental Exchange paid $650 million for Creditex, earning Meeks four times his investment and launching him to number 83 on the Forbes Midas List of tech dealmakers.
A few years ago merely quadrupling an investment over five years would not have given you anything to brag about in the exclusive club on Sand Hill Road. John Doerr of Kleiner Perkins Caufield & Byers and Michael Moritz of Sequoia Capital (numbers one and two on this year’s list) earned hundreds of times their money by putting it into Google and Yahoo when those firms were barely business plans.
Now Meeks’s game – investing in adolescent companies whose managers have already figured out how to turn a profit – looks like the smartest strategy in town. “Returns don’t come from being the gray-haired coach and building companies from scratch,” Meeks says.
Over the past five years early-stage investments have given VCs’ limited partners a return of 5%, roughly the same payout as a Treasury bond index. Late-stage deals have returned 12%, according to the National Venture Capital Association. The recent collapse of the new-issues market, where early-stage VCs have historically notched their biggest wins, has made things even worse. Many VCs and some limited partners are now wondering whether the early-stage investing model is permanently broken. They are moving on from acorns to saplings – what are called “growth equity” investments.
The dollars in play in growth equity have, of course, been smaller. In 2006 half of all the venture money raised, $15.7 billion, was put into funds doing only early-stage investing. Only 8%, or $2.6 billion, was earmarked for exclusively late-stage vehicles. But the slow yet steady returns of growth equity firms are attracting competition from the players of startup lotto. In 2007 and 2008 VCs raised $15 billion for late-stage venture funds, double the amount in the previous two years and 25% of the total take for all venture funds.
Do not expect the superior returns to last, however. “When everyone is rushing in to the same space, prices on deals will get bid up and returns will fall,” warns August Capital’s Howard Hartenbaum, an exclusively early-stage investor and number 13 on the Midas List.
Switching from early- to late-stage investing also means a big change in attitude: Venture capitalists must adopt the bullheadedness of a fullback rather than the flashiness of a star quarterback. “Most of these new entrants have no business doing growth deals,” scoffs Douglas Leone, a partner at early-stage juggernaut Sequoia Capital and number 39 on this year’s list, who helped his firm muscle into growth-equity investing in the 1980s.
Growth deals are heftier – $9 million on average, but occasionally reaching more than $100 million, compared with seed investments of $1 million to $5 million. The targeted returns are more plodding – three to five times – and the expected success rate is higher, perhaps 3 in 4 rather than 3 in 10. “In the venture business you have a lot of people who are artistes who do things to create a business,” says number 42 Midas lister Bruce Evans, managing director at Summit Partners and growth-equity backer of OptionsXpress, which now has a market cap of $700 million. “We are investors and salesman first.”
Meeks learned the humility and number-crunching ethic of growth investing during his 20s as a junior employee at TA Associates in Boston. He spent 13 hours a day scouring trade journals and databases for potential deals, cold-calling chief executives and drafting deal memos.
The template that Meeks followed dates back to 1968, when Peter Brooke, a partner at Boston investment bank Tucker Anthony, started an internal venture fund to compete with the dominant early-stage investors of the time: the investment offices of wealthy families such as the Phippses (Bessemer Securities) and the Rockefellers (Venrock). Among Brooke’s early hires was C. Kevin Landry, then a recent Wharton School M.B.A. who had helped pay for his education by driving a cab.
Landry (now number 29 on the Midas List) had deal hunters like Meeks looking for fast-growing, young tech companies. The diggers called those firms’ founders and tried to glean bits of data about the firm’s industry and finances. These days 30 associates call about 5,000 companies a year. That information along with extensive databases gets poured into a collection that now includes statistics on 350,000 privately held companies.
Companies are categorized as unsuitable targets, interesting but too young, or potential investments. Associates are compensated, in part, based on the number of companies they convince to meet with TA. When a company is denoted as a possible investment, TA sends out two partners to scrutinize the firm’s operations. TA visits approximately 1,200 firms per year and invests in 10 to 12.
THE BEAUTIFUL SIDE OF CAR PARTS
O’Reilly Automotive may be best positioned to benefit from demand for the “aftermarket” auto parts needed to keep aging jalopies on the road.
In Part 3 of the annual Barron’s Roundtable, covered here, Mario Gabelli gave a favorable but brief mention of O’Reilly Automotive. It is not selling at a superlow multiple, being more of a growth story. Here is the stock’s story in more detail.
The meltdown of the auto industry last year was vicious and widespread – and the outlook for 2009 is hardly much better. The consensus among industry insiders is for a 13% drop in sales, following an 18% plunge in 2008.
Amid the gloom, however, there is a notable bright spot: the market for auto parts used for maintenance and repair. Rather than buy new cars, cash-strapped Americans are making do with their existing ones. The average age of a car on the road, which climbed from 9.3 years in 2001 to 10.1 in 2007, is only going higher. And all those jalopies need plenty of fan belts, exhaust pipes and brake pads to keep running.
The upshot: The $215 billion “aftermarket” for auto parts has not shown the slightest decline, and is likely to hold up well for months to come. And that spells opportunity for the chains that specialize in such parts.
Under normal circumstances, outfits like Advance Auto Parts (AAP), AutoZone (AZO), O’Reilly Automotive (ORLY) and Pep Boys (PBY) would have been battered, like most U.S. retailers, which expect a grim 2009. [See table of comparative stats here.]
But the car-parts stores have one big factor working in their favor: Their wares are far less discretionary than, say, cashmere sweaters and iPods. Although motorists may delay maintenance in hard times, they eventually cannot put it off if they want their vehicles to perform well. O’Reilly CEO Greg Henslee says that American motorists could be as much $60 billion behind in their maintenance – meaning that some of the chains should see their business pop later this year.
Of all the companies in the field, O’Reilly is probably the most appealing. ... While smaller than some rivals, O’Reilly has two big advantages. First, about half the revenue at its core stores comes from commercial sales to repair shops and the like – more than most of its peers. Commercial business is less cyclical than consumer spending. O’Reilly also stands to benefit from the $1 billion acquisition last summer of CSK Auto, another parts retailer. At the time, the deal was not particularly applauded, with investors worried by weak sales and margins at CSK. O’Reilly’s stock traded down from more than $30 before the deal to as low as $21 last autumn. It has since rebounded to around $28. But with CSK, in one swoop O’Reilly added 1,342 stores in 22 states, a nearly 85% increase (to more than 3,000) from O’Reilly’s previous 1,774-store network. Many of the new locations are in the western U.S., where O’Reilly had not been well-represented.
Last summer, analysts concluded that full integration of CSK would take two years or more. Six months later, while it is still likely that the full payoff will not show up before 2011, it looks as though integration is going faster and better than expected. “Hopefully, we will do well this year, certainly well in relation to the poor economy,” says Henslee.
The first step was to focus on eliminating duplicate overhead by merging or closing some outlets. The company must boost profitability at CSK, where the 2007 operating margin was 2%, versus O’Reilly’s 12.1%.
In part, the plan is to boost CSK’s commercial sales, which had accounted for just 17% of its total. Further gains should come from adding regional distribution centers to the CSK chain, allowing the stores to be better-stocked. Pre-deal, CSK had one distribution center for every 335 stores, versus O’Reilly’s one per 130. “O’Reilly’s business model, variable labor costs and supply-chain logistics are among the most efficient in the industry,” says Cid Wilson, director of research at New York-based investment firm of Kevin Dann & Partners. “It will take O’Reilly 12 to 18 months to bring CSK totally up to its standards, but we will start seeing slow, steady improvements over this year, improvements that will restore investor confidence. I see the stock rising 50%, to $42, within 12 months.”
O’Reilly is set to report full-year earnings around $1.56 a share, versus $1.68 in 2007 – although an earlier-than-expected CSK turnaround could trim the decline. For the new year, Wilson sees profit up 20%, to at least $1.90. If he is right, O’Reilly’s stock, like a well-maintained muscle car, could have plenty of miles ahead.
ANTICIPATING THE RETURN OF THE KETCHUP KID
The king of ketchup – and many other products – looks like the food industry’s most appetizing stock. In a takeover, it will be a gravy train.
Heinz has a record of consistently high returns on equity and cash generation. But for almost a decade its earnings went nowhere. The company may have finally put that episode behind them as earnings per share are up almost 40% in the past three years. The stock has fallen to a P/E of around 12 and yields almost 5% – with about as secure a dividend as they come these days, we might add. Definitely worth watching, if not buying.
After lagging badly behind all its major food rivals in the equity market over the past six months, Heinz might have this defensive group’s most appealing stock.
At around $36, H.J. Heinz shares (HNZ) combine a reasonable forward price/earnings multiple of 12 with one of the food industry’s highest dividend yields, 4.6%. The stock has slid 27% in the past six months, versus an average drop of about 10% for its peers.
Compared with other big food companies, the 140-year-old Heinz has an above-average portfolio of brands, led by its dominant global ketchup franchise – it sells more than 650 million bottles each year. Other big products are Ore-Ida and Smart-Ones frozen foods in the U.S., and market-leading Heinz soups and baked beans in the U.K. Nearly all its major brands are #1 or #2 in their categories.
Heinz is expected to earn about $2.90 a share in its fiscal year ending in May, up 10% from $2.63 it earned during its fiscal 2008. It trades for 12 times estimated profits in the current fiscal year and it carries a similar multiple on estimated calendar 2009 earnings, a discount to Kellogg , Kraft Foods and General Mills, which fetch about 14 times estimated 2009 profits. [Table comparing package food stocks is here.]
Heinz’s dividend, unlike those of many stocks offering nice yields, looks safe because the company is paying out less than 60% of its profits, and food earnings tend to be predictable. Heinz, which calls its dividend a top priority, has lifted it in 40 of the past 41 years. It is likely to do so again in May, although the boost may be only about 5%, well below last year’s 9% rise.
Food stocks may not have the appreciation potential of more volatile and depressed industry groups. Yet given Heinz’s low valuation, it could rise smartly in the next year. Citigroup analyst David Driscoll carries a Buy rating on the stock and a 45 price target, well below its September high of 53. If the stock rises to 45, investors could realize a not-so-shabby 30% return, including dividends. If profits disappoint, the stock’s downside is likely limited to 30.
Heinz’s business outlook probably is no worse than that of Kellogg (K) and General Mills (GIS), and it is better than that of Kraft (KFT), which has struggled to lift profits since it went public in 2001.
“Heinz is clearly inexpensive now,” says Mark Boyar, who heads Mark Boyar & Co., a New York investment and research firm. Heinz, he says, could become a takeover candidate in the next few years for the likes of Nestlé (NSRGY), Kraft or Unilever (UN). Heinz has a digestible market value of $11 billion and, unlike Campbell Soup and Hershey, it has no controlling shareholder that can block a deal.
Given tight credit markets and the global recession, there is little chance of a deal for the company anytime soon. But Boyar believes Heinz ultimately could fetch 60 to 70 a share. That would be in line with what InBev (INBVF) paid last year for Anheuser-Busch – about 20 times earnings.
From 1998 to 2006, Heinz’s profits and stock price languished amid a series of restructurings, acquisitions and divestitures. Since then, the company’s business and financial performance, under the leadership of CEO William Johnson, have markedly improved, due in part to Heinz’s decision to adopt much of the playbook advocated by activist investor Nelson Peltz, whose Trian Partners took a stake in Heinz in 2006.
Peltz urged Heinz to invest more heavily in its key brands and focus on new products – while cutting overhead costs, closing factories and slashing payments to retailers to stock Heinz products. One result: its successful new Ore-Ida “Steam n’ Mash” frozen potatoes. In the three years since Peltz came on the scene, Heinz’s profits per share are up nearly 40% – but the stock price is back where it stood then.
A few issues are dogging Heinz. Currency hedges that protect Heinz’s profits from a strengthening dollar are helping earnings in the current fiscal year. But Heinz will not benefit from the hedges in its next fiscal year, starting in May, and that could depress earnings by up to 25 cents a share. The upshot could be little or no earnings growth for the year, below Heinz’s target of 8% to 11% in annual gains.
Another problem: Peltz’s Trian recently cut its Heinz stake to 2%. Both Heinz and Trian are downplaying the move, with a Trian spokesman telling Barron’s Online recently that the firm “continues to be very pleased with its investment in Heinz” and that the sale is part of a “portfolio adjustment.” Still, the Trian action clearly has raised concerns on Wall Street about more Trian sales.
Then, there is the economic backdrop. Food stocks should benefit as more Americans, and consumers around the globe, prepare more meals at home. However, branded food companies like Heinz could suffer at the hands of private-label brands.
None of that, however, seems to be fazing the management team at Heinz.
“We feel we are very well-positioned given the strength of our brands,” says Chief Financial Officer Art Winkleblack. “I am sure glad we are selling food and not washing machines or cars. People are coming home to Heinz.”
That looks to be true not only in America but overseas, where Heinz now gets more than half its sales.
Heinz’s most important international market is the U.K., where it generates 20% of total sales. Thanks to a long-standing presence, Heinz controls almost 80% of the British ketchup market, which is above the company’s U.S. market share. It also has more than half the canned-soup market, with English staples like cream of tomato. And Heinz dominates in baked beans, a British breakfast favorite with toast.
Heinz also is Italy’s leader in baby food with its Plasmon brand. Further afield, it has done well in Russia with ketchup and in China with baby food. Heinz gets 14% of its sales from developing markets, and has good prospects in those growing economies.
Amid shaky global markets and economies, this food maker’s shares look more appealing than most. With a low P/E, an ample and safe dividend, and the possibility of takeover down the road, Heinz could be a zesty investment.
SHARES OF CORN PRODUCTS INTERNATIONAL OFFER A SWEET ENTRY POINT
Failed buyout creates value opportunity.
Corn Products International is a economic badtimes-resistant stock with some exposure to agricultural commodity prices – if you think those are coming back any time soon. Agricultural giant Bunge agreed to buy out Corn Products last summer, but with the collapse in both commodity prices and credit availability the deal fell through, and was called off in November.
Now you can buy CP at well less than half the buyout price. Keeping in mind that this price was set during higher spirited times, that still seems cheap for a business that is not going to be disappearing any time soon, notwithstanding the cyclical component to its earnings. The current CEO is planning to retire and there is no obvious successor in sight, which in combination with the failed former buyout makes the prospect of a future sale nonnegligible.
Agricultural-products giant Bunge tried to satisfy its sweet tooth last summer, agreeing to buy corn processor and sweetener supplier Corn Products International (CPO) in a $4.4 billion stock deal. But the deal turned sour when Bunge’s (BG) stock collapsed amid the severe slump in commodities, prompting Corn Products to nix the proposed takeover in November. Result: Investors can snap up shares of a recession-resistant outfit with a strong balance sheet and solid management for less than half the $56 a share that Bunge agreed to pay.
Corn Products is changing hands at 26, well below the 43 it fetched just before the deal was announced late last June and the 54.96 it hit just after the news. [In late February the stock traded below 20.] Bulls say the link to Bunge, which has seen its earnings and share price drop off a cliff, is still depressing Corn Products’ stock – and that should soon change.
Westchester, Illinois-based Corn Products, which is expected to have about $4 billion in 2008 sales, may end up at the merger table again, perhaps even with Bunge, when the credit market recovers. In the meantime, Corn Products shares may revisit the 40 level over the next year if corn prices stabilize, as some analysts expect. With its ability to raise prices, expand to ancillary businesses and improve product mix, the company could meet or beat quarterly estimates, as in 2008’s third quarter.
Overall, analysts expect Corn Products to produce low double-digit earnings-per-share growth in coming years. In addition, cash flow is strong and the balance sheet is healthy, with debt just 29.4% of capitalization. Investors are valuing Corn Products at just eight times the $3.24 a share analysts expect the company to earn this year, below the average historical forward price/earnings ratio of 17. Affixing, say, a 13 multiple to consensus estimates values Corn Products at about 42, or 65% above its current price.
“It’s a value story created by the failed Bunge acquisition,” says Henry Cauceglia, research director at Cresskill, N.J. risk-arbitrage firm Alpine Associates, who bought CPO shares soon after the Bunge deal was announced.
Founded in 1906, Corn Products makes sweeteners, including high-fructose corn syrup, and starches, for sale to pretty stable end markets, such as processed food, beverages and health care. Close to 40% of the company’s $3.4 billion in 2007 sales came from outside North America. It gets about 20% of revenue from co-products such as corn oil and corn meal.
After topping $7 a bushel last summer, corn now fetches $3.60 or so. Some analysts see prices trending to at least $4 this year. Corn Products made hay when prices were high, and is on track to post record results for 2008. After recording a 74% jump in earnings per share in Q3, management raised full-year estimates to a range of $3.40 to $3.60 a share, at least 31% above 2007’s $2.59.
Higher corn prices cut both ways for Corn Products. Profit gets squeezed when corn prices rise, as the commodity represents 40% to 60% of their products’ unit costs. The company mitigates that risk somewhat by locking in much of its volumes for starches and sweeteners, as well as corn costs, in annual and multiyear contracts. Tight capacity can drive Corn Products to raise prices. The company is negotiating contracts that some analysts think could result in 2009 price increases of 9% to 10% in North America.
The company can also benefit from high corn prices by charging more for its co-products, offsetting increased costs. That balance worked well in the 3rd quarter, when higher co-products pricing offset a 30% increase in gross corn costs. Now, with corn prices lower, management puts Q4 earnings at 50 to 70 cents a share, warning of lower co-product prices and currency volatility. Consensus is 63 cents. Officials declined to comment for this article, citing the quiet period ahead of the February 2 earnings release.
While full-year earnings are expected to fall below 2008 levels, an unexpected uptick in corn prices could lift results above consensus. Furthermore, rapidly growing ancillary businesses could also boost results. BB&T Capital Markets analyst Heather Jones notes that new applications for corn products, including fertilizer, insulation and personal care products, are already generating about $200 million in annual sales.
However, some analysts have cut their ratings and earnings estimates on the stock, citing weakening co-product demand and currency risks. “A global slowdown and a reduction in pricing of competing starches should limit the company’s intermediate-term ability to recapture foreign-exchange losses through pricing,” said Deutsche Bank analyst Christina McGlone, downgrading CPO’s shares to Sell from Hold on January 16.
Management’s other main challenge: Find a successor to Chief Executive Samuel Scott, 64, who is retiring after leading the company for eight years. Analysts, who give Scott & Co. high marks, have not identified likely candidates yet. BB&T’s Jones thinks Scott, the largest insider stockholder, with about 200,000 shares, “will not leave until he is fully satisfied the company is in capable hands.”
Absent another deal, the payoff for investing in Corn Products might be some time away – but the yield promises to be just as sweet.
WHERE TO SPOT THE NEXT BULL MARKET
No signs yet that the bull is waking up.
Those who claim to see lots of value out in the marketplace and that therefore you should step up to the plate might want to ask where the money is going to come from. Now usually this has not been a very intelligent question. Bull markets generate their own funding to a point. Or they did, during times of credit expansion – a regime which all but the oldest among us have lived our whole lives under. But credit is contracting, and looks like it may be more than the growth slowdown or temporary flatlining which have constituted “credit contractions” during the post-war era recessions. Then what?
There are several outfits which track money flows into and out of the world financial markets – no easy task, needless to say. The head of one such outfit, Charles Biderman of TrimTabs, says we really only need to look at one indicator to gauge that the market is getting ready to turn around: insider buying, including buybacks and takeovers. These buybacks are down about 90% versus a year ago. No signs of the bull returning yet. “This is the worst market I have ever seen,” says Biderman, who has been watching markets since 1973 – the beginning of the formerly worst bear market since the 1930s.
How will we know when the bull is off and running again? Follow the money, says Charles Biderman, chief executive officer of TrimTabs. His Northern California research outfit is one of several that track the many flows into and out of the world reservoir of monetary value – what we call money. No small task. Cash flows – debits and credits to be precise – constantly swirl among central and commercial banks, money markets, Treasury bills, stocks, bonds, payrolls, tax coffers – to name a few. This reservoir also has some swamp-like features: The muddy, hard-to-follow cross-currents’ velocity and direction need to be assessed against long-term economic cycles.
Much of the data is useful in measuring the breadth and depth of the market’s primary trend. But in our current economic circumstance, only one money flow is a reliable indicator that the bull is getting frisky.
“The first sign of a turnaround will be corporate insiders buying their own stock again and boards announcing new stock buybacks and cash takeovers of other public companies,” says Biderman (banks buying banks with donated tax dollars do not count). Right now, such buybacks are off about 90%, year-over-year.
No doubt you have heard about the huge pile of cash “sitting on the sidelines” that would buoy the market if even a portion flows into equities. But in the current economic climate, not all the cash is truly liquid – that is, free to change locations.
For example, the Investment Company Institute, the trade group for mutual funds, estimates that almost $4 trillion is sitting in money-market funds. But about 2/3 of that is institutional money, notes Biderman, much of it probably earmarked as reserves against shareholder redemptions or committed to retirement and other long-term purposes. “The money coming out of equity mutual funds is greater than that going into bank [certificates of deposit], money markets or other savings,” notes Biderman. “The money is disappearing because people are using it to live on.”
TrimTabs’s various liquidity services track and interpret all significant monetary flows. Subscriptions are priced for multiple or institutional buyers that run into the thousands of dollars. But the site also is a treasure trove of free content – research papers, tutorials, press releases, commentary; while waiting for TrimTabs to call a market turn, visitors can bone up on different flow scenarios.
Biderman’s primary recommendations when asked about investment ideas for Barron’s readers: Short the exchange-traded Financial Select Sector SPDR (XLF) and Consumer Discretionary SPDR (XLY), as he still sees downside. If you go long, stick to companies with strong cash flow and balance sheets, or respected bond funds invested in highly-rated corporates. Energy Select Sector SPDR (XLE) may also be a play, since “of all industry groups, energy is the one with the most current insider buying,” he says. Corporate boards and insiders will not start doubling down on their own issues again until they regain confidence that personal and corporate incomes will turn up, says Biderman.
The Conference Board also takes CEO temperatures quarterly, making the results available for free on its site. The most recent poll: CEO confidence is at its lowest level since the board began measuring in 1976.
Another place to watch for a turn in C-levels’ pluck and mettle is InsiderScore.com. While priced for institutions, the insider-trading tracker offers a free 14-day trial. (Like TrimTabs, InsiderScore does not discuss specific prices)
Of course, there is a whole lot of nothing happening right now, says Director of Research Ben Silverman. But watch this space: The site not only tracks trades, but also handicaps the traders to reveal who is hot and who is not.
For a higher-level view of market macro, check ICI’s Stats and Research page. The institute offers an advantageous perch for watching flows since its reporting members manage approximately 95% of the assets held in mutual funds, exchange-traded funds, closed-end funds and unit investment trusts. ICI also publishes the Investment Company Fact Book, a free year-end roundup of its findings.
And don’t worry, there is time to get comfortable with all this information. There is no sign yet that the bull is waking up.
“Bottom line: This is the worst market I have ever seen,” says Biderman, “and I’ve been watching markets since 1973.”
WARREN’S UNHAPPY NEW YEAR
Warren Buffett’s affinity for a group of financial stocks probably is dragging down Berkshire Hathaway’s vaunted equity portfolio this year.
Even great investors make mistakes. Warren Buffett’s affinity for a group of financial stocks, including American Express, Wells Fargo and U.S. Bancorp, is likely hurting his equity returns in 2009.
Buffett’s Berkshire Hathaway has sizable holdings in that trio, and the sizable declines in their share prices this year are dragging down Berkshire’s (BRKA) vaunted equity portfolio, which totaled $76 billion at the end of the 3rd quarter, the latest reporting period.
We estimate Berkshire’s equity portfolio could have dropped 14% in 2009 through Thursday (1-22), against an 8% decline in the S&P 500. Our estimate is based on the change in value of Berkshire’s 16 largest equity holdings [see table]. These holdings historically have accounted for over 85% of Berkshire’s portfolio. The tough 2009 follows a good showing in 2008, when Berkshire’s equity positions declined – by our estimate – about 25%, 13 percentage points better than the S&P 500. Our calculations for 2009 are based on Berkshire’s reported holdings on September 30. There admittedly may have been some changes since.
Wells Fargo is Berkshire’s biggest loser in 2009, as shares of the California bank were down nearly 50% through Thursday to about 16. Buffett could not be reached for comment, but his view on the financial sector has been to buy quality. At Berkshire’s annual meeting last May, Buffett said: “We like the culture at Wells Fargo, M&T and U.S. Bancorp. In all three cases, I understand the DNA of management. That does not mean they won’t have problems,” according to a meeting attendee. (Berkshire owns a stake in Buffalo’s M&T Bank [MTB].)
Our guess is that if any of these companies needs an equity investor, Berkshire stands ready to help. And the stocks are so volatile they could turn higher at any time.
The paper losses on Berkshire’s equity portfolio this year, plus losses on its short position in some $37 billion of equity puts, have depressed Berkshire class A shares, which finished Friday at $86,250, down 10% in 2009. Barron’s wrote bearishly on Berkshire in late 2007 when the stock traded at $144,000 and we turned bullish in late November with the shares just above current levels.
When it reported Q3 results in November, Berkshire said shareholder equity fell by $9 billion, or nearly $6,000 a share, through the end of October given weak markets. We estimate book value probably ended 2008 around $70,000 a share. Current book value may have dropped close to $67,000 a share. If we are right, Berkshire trades for a still-reasonable 1.3 times book value and 14 times projected 2009 earnings of around $6,000 a share.
After a flurry of high-profile investments in early October, including $5 billion in Goldman Sachs preferred carrying a 10% dividend, and a similar $3 billion deal involving General Electric, Berkshire has not unveiled any big new investments. Why? Our guess is that its once-enormous cash hoard has been depleted.
Berkshire’s insurance cash holdings, which stood at $27 billion on September 30, likely fell to $13 billion after the Goldman and GE deals, as well as a $6.5 billion investment in junk bonds and preferred stock of Wrigley, which was bought by Mars. Berkshire also is on the hook for a $3 billion convertible preferred-stock investment in Dow Chemical if it completes its purchase of Rohm & Haas. Some investors say Berkshire likes to keep $10 billion of cash to deal with unexpected insurance claims arising from an earthquake or hurricane. This would not leave Berkshire much cash for a big investment unless it sells something or takes on debt.
Our guess is that if Berkshire did make more 4th-quarter investments, they were focused on the battered junk-bond market. Berkshire will disclose more on investments in its annual report, due around March 1.
A POOR MAN’S BERKSHIRE HATHAWAY?
Investment firm Compass Diversified can buy solid businesses at a discount thanks to its cash hoard. And its stock is cheap.
Comparisons to Bershire are preposterous, but Compass Diversified is nevertheless an interesting company which was previously unknown to us. The P/E is quite low ... if the earnings come through. The allegedly secure dividend gives the stock a yield of 14% plus. The market must doubt that the dividend will be maintained. How valid is that doubt? Cash flow from operations could fail to cover the dividend this year, but an analyst who likes the stock says, “we are in trough year.” Well pardon our skepticism about the “trough year” prediction. When/if the dividend is cut this is probably worth a real look.
The credit-lending and private-equity spigot has been welded shut for a vast number of companies seeking financing to survive and grow. But Compass Diversified Holdings (CODI), an investment firm with loads of cash on hand, is taking advantage of this environment.
Trading at $10.33, Compass shares are down 31% since last February’s highs, tumbling amid the broader U.S. financial meltdown. Certainly, investors should be cautious treading here: As a small-cap company with thin trading volume, Compass is a highly speculative play.
Growth will likely be damped this year, but Compass is well equipped to weather this economic storm. It is flush with more than $400 million in available cash and untapped credit as it scours the U.S. for its next investments.
This cash also ensures that Compass will continue to pay out its dividend – currently yielding a whopping 14% – even if cash flow from its portfolio of companies comes in short due to economic pressures.
The stock looks cheap at 0.7 times its estimated book value of $15.21 and a dividend yielding more than five times the benchmark 10-year Treasury. Historically, its normal yield has been around 8%-9%, notes Stifel Nicolaus analyst Greg Mason.
Compass’s operating structure is widely misunderstood. It is frequently lumped in with so-called business development corporations (BDCs) and private-equity firms.
American Capital (ACAS) and other BDCs have to pay out 90% of their income to shareholders and make mainly debt investments in hundreds of companies.
Generally, both private-equity firms and BDCs have relied on third-party credit providers for the funds used to make acquisitions. But Compass has its own cash and an established credit line for funding its purchases. The company retains a significant portion of its cash flow for investments. It also has a small, actively managed portfolio of five to eight companies at any time.
Compass shares have held up relatively well compared to shares of American Capital and private-equity firm Blackstone Group, which are down 80%-90% since their early 2008 highs.
In the near term, news of an acquisition plus proof that the company can “continue to show their ability to generate enough cash flow for distribution” could push Compass shares higher, says SMH Capital analyst Will Hamilton. Hamilton rates Compass at a Buy, mainly because the company has “a very strong management team that we give a lot of credit for in terms of their ability to identify attractive companies while also being very disciplined in how much they pay [for them].” ...
Compass’s portfolio is pretty transparent unlike BDCs because it reports financials for each company quarterly. Compass’s team, led by Chief Executive Officer Joe Massoud, is focused on growing market share for each niche business, along with cutting costs. Acquired companies retain their management teams
s “We do not have a whole lot of leverage, only about $60 million net debt. We do not have real amortization issues, but we have real liquidity,” he says. “This is the time to take advantage of less-capitalized competitors.” Better market positions will ultimately “mean more cash flow” when the economy starts to recover, he adds.
The biggest contributor to Compass’s fortunes is CBS Personnel, making up 40% of earnings before interest, taxes, depreciation and amortization (EBITDA). CBS derives 95% of its revenues from temp placements of low-to-midskilled industrial, clerical, technical, health-care and other niche workers. This is the reason that Compass often trades in tandem with staffing pure plays such as Robert Half International (RHI), notes Mason of Stifel Nicolaus.
Morgan Keegan analyst Robert Dodd estimates cash flow can fall 12% at CBS in 2009 due to bleak employment numbers. But even with a “pretty steep” decline, Compass will be able to cover its dividend thanks to stability in other less-economically sensitive businesses.
Advanced Circuits, which provides universities and researchers with circuit boards, generates 21% of Compass’s EBITDA. The rest comes from Fox Factory, the maker of suspension for biking enthusiasts; low-end furniture from American Furniture; Halo Branded Solutions, a leading distributor of customized promotional products; and Anodyne.
Massoud does not expect to sell off any of these companies until 2011 at the earliest. He is shopping around for companies nearing cyclical bottoms and some potential medical-device companies. Compass is also hearing from potential sellers who balked less than six months ago, adds Massoud.
Meanwhile, Janney Montgomery Scott analyst John Rogers estimates that Compass can generate a compound annual earnings growth rate of 10%-15%.
Cash flow could come in less than the dividend this year, but Rogers says, “we are in trough year.” His price target of $15 implies a 42% upside to the stock price and total returns of close to 60% over the next 12-18 months.
So while Compass stock has clearly lost its way, the secure dividend and focused management team could help it find due north again.
BOND MARKETS REACT TO RISING GOVERNMENT DEBT
Are the “bond vigilantes” back?
A couple of years ago we posted a humorous piece from a PrudentBear.com writer titled “Don’t Look Now, Mr. Bernanke, But We’re Back!: The Bond Vigilantes ride again.” (See this page.) The idea was that the bond vigilantes were waking from their long somnolence (of around 25 years when the piece was written) and would be inclined once more to punish central banks who inflated too vigorously. That premise did not really prove out, but the vigilantes’ lost first cousins may yet be getting ready to mete out justice to erring governments.
The incoming Obama administration got a rude reception from the debt markets. Ed Yardeni, who coined the term “bond vigilantes” back in the early ‘80s, sees them being roused again. Then, the vigilantes’ main target was inflation; now it is burgeoning budget deficits around the globe.
The eponymous head of Yardeni Research notes that the Congressional Budget Office is projecting a fiscal 2009 budget deficit of $1.2 trillion – 8% of U.S. GDP. And that is before President Obama’s $800 billion stimulus plan. The CBO also accounts for the discounted present value of the TARP returns, which brings its cost down to $180 billion this year from the likely $700 billion cash outlay.
Taking all that into account, Goldman Sachs estimates that the Treasury’s cash borrowing needs may hit $2.5 trillion this year. Against this backdrop, incoming Treasury Secretary Timothy Geithner threw down the gauntlet to America’s biggest creditor, China, accusing it of currency manipulation.
Little wonder that long-term Treasury yields have been moving up, while the cost of insuring U.S. government debt in the credit-default swaps market has widened sharply, back to their largest levels reached in December. The benchmark 10-year note moved back above 2.50% last week (ending 1-23), to 2.62%, an increase of 30 basis points from last Friday.
That’s resulted in a marked steepening of the Treasury yield curve. The spread between the 2- and 10-year notes has jumped to 182 basis points, about a 50-basis-point increase since the year began, as long yields moved up while the short end has been anchored by the Federal Reserve’s target of 0-0.25% for the federal-funds rate.
Policymakers may address this at this week’s meeting of the Federal Open Market Committee. Chairman Ben Bernanke has talked of buying longer Treasuries to cap longer-term interest rates, and the Fed has already begun buying agency mortgage-backed securities.
Whether purchases of longer maturities would quell the market’s concern is another question. Thursday, CDS on U.S. Treasuries were quoted at 73 basis points, according to Tim Backshall, chief strategist at Credit Derivatives Research. (That means paying €73 annually to insure €10 thousand worth of U.S. debt. Obviously, Uncle Sam can reel off all the greenbacks he needs to pay off his debt. So the CDS on U.S. Treasuries are quoted in euros, a currency the U.S. cannot print.)
That is up sharply from 60 basis points a week earlier and 40 basis points on November 20, when the S&P 500 hit its recent low. The stock market’s gain apparently has come at a cost to Uncle Sam, as the first half of the $700 billion Troubled Assets Relief Program was exhausted and the second half was requested in the waning days of the Bush administration.
James F. Keegan, chief investment officer of Seix Investment Managers and a portfolio manager of the Ridgeworth Intermediate Bond Fund, puts it bluntly: The government’s massive efforts to bail out the banks “are putting the sovereign credit of the U.S. at risk.”
This sort of risk rippled through the global government bond markets. Bond vigilantes are exacting increased yields – not because of expectations of inflation, but precisely the opposite. Amid worsening debt deflation and recessions in Britain and the rest of Europe, governments there also face enormous fiscal deficits, in part to bail out their faltering banks.
Nowhere has the international vote of no-confidence been stronger than in the U.K., where it is been evidenced by the pound’s stunning collapse. Sterling has plunged since the global financial crisis intensified late last summer, to below $1.40 from over $2.00 as the tab for the U.K. government’s bailout has soared. The cost of insuring British government debt has soared. ...
“Countries don’t go broke,” declared the late Walter Wriston, a former CEO of the banking company that these days calls itself Citigroup. That was in the early 1980s, just before that era’s Latin American loan crisis erupted.
But when global capital flees a nation’s currency and government securities, the bedrock of its financial system, the world has expressed doubts about that country’s ability to meet its liabilities.
The citizens of Zimbabwe do not want to hold the country’s currency for more than a few hours at a time if they can avoid it. Who can blame them, with prices doubling by the day? (In percentage points that translates to an annual inflation rate that calls for a 112-digit number.) But some currency collectors are hot for the money, now that the denominations are taking on comic proportions. The latest issue from the central bank is in multiples of a trillion (Zimbabwean) dollars.
Donald MacTavish, 30, a printer in Springfield, Massachusetts, peddled Iraqi dinars but switched his attention to uncirculated Zimbabwean dollars after hearing of the new notes. He has been paying $5 to $12 per bill to buy and ship the (obsolete) billion-dollar bills and has been selling them for $25 to $45. MacTavish thinks the trillion-dollar bills might go for $100 each. Karen Brown, a collector from Sussex, U.K., thinks values will only improve because each series of notes is printed only for a few weeks.
But currency dealers are not so sure. “Zimbabwean dollars will never have a value because they exist in such abundance,” says Kevin Foley, senior numismatist at Bowers & Merena, an auction house in Irvine, California.
Notes from Rhodesia, the country that Robert Mugabe turned into Zimbabwe, are still worth something, maybe to people nostalgic for British colonialism. A $10 or $20 note issued between 1965 and 1969, if in sparkling condition, is worth a few hundred dollars. That has to grate on the old dictator.
Mining Pullbacks Presage Pop
Mining has been a dirty business lately. As demand for metals and minerals collapses, miners have responded by slashing spending and cutting production, and their share prices have been panned: The Dow Jones Stoxx 600 index basic resources sector has lost almost 60% of its value in the past 12 months. But by reducing output and holding back supply, mining companies are also, in effect, setting up the next rally.
The sector may hold some gems for investors who are prepared to wait at least 18 months – or two years.
Last year, Credit Suisse estimated that about $50 billion of mining capital expenditure could be delayed in 2009, putting off by two to three years production of about 300 million metric tons of iron ore, 5 million tons of copper, 10 million tons of aluminum and 1 million ounces of platinum.
“Mines by their nature deplete every day. If you are not replacing capacity ... when the market moves into deficit, there will be an explosive reaction from the metal prices. So, by cutting all the capex for the mines that will come into production in the future, you are really sowing the seeds of the next bull market,” says Evy Hambro, fund manager for BlackRock’s $4.8 billion world mining fund and $4.6 billion world gold fund.
Rio Tinto (RTP), Anglo American (AAUK), Xstrata (London Stock Exchange: XTA) and others made some top-of-the-cycle acquisitions, stretching balance sheets and, in Xstrata’s case, prompting a massive rights issue. That means most miners are conserving cash – eliminating capital expenditures, suspending share buybacks, dropping acquisitions and laying off workers, among other things. Just about every miner in the sector is pulling back on big new projects that were expected to deliver the next wave of supply.
BHP Billiton (BHP), the world’s biggest miner, appears to be a good defensive bet. It has a strong balance sheet and will continue to turn a profit even if commodity prices dive further. Also, with its relatively small debt, BHP is one of the few miners in a position to be able to snap up good assets, or even whole companies.
Its trailing 12-month price/earnings multiple has climbed to 7.5, but that is still below its 5-year average of 11.7. Its shares have been resilient over the past 12 months, though on Friday it closed at 1181 pence, down more than 7%. Deutsche Bank has a 1617-pence target on BHP.
Xstrata and Rio Tinto are much riskier investments, but worth a look. Both have been burdened by debt-related concerns, and investors have responded with a massive selloff. That makes them, at least historically, great bargains. Xstrata’s 12-month trailing price/earnings multiple has gone down to 2.4 from a five-year average of 14.5, and Rio Tinto to 3.8 from 15.6. In the meantime, Xstrata is shoring up its balance sheet with a massive rights issue, indicating the worst may be behind it. The Anglo-Swiss miner should be able to emerge from today’s economic storm in a position to resume an aggressive growth strategy. Goldman Sachs has an 894-pence target price on Xstrata.
“There are clearly opportunities around,” said Scott Meech, manager for institutional pension funds and a member of the basic materials global sector research team at Threadneedle. “We are keeping a close eye on things right now.”
Nickel Market Still Soft
Despite a mini-rally at the start of the year, nickel prices are skidding and will likely plumb further depths as the global economy sputters. As with other base metals, commodity-index rebalancing briefly propped up prices in the first weeks of 2009. But the gains quickly evaporated. London Metal Exchange 3-month nickel closed Friday at $11,150 a metric ton, down 8% on the week. And the contract is off 17% since the start of the year.
60% of nickel’s production is used in stainless steel, and with steel demand slim, nickel is expected to retreat toward $10,000. Nickel producers who have already slashed output will be forced to cut more. ...
LME nickel prices have fallen by around 80% from their record high near $50,000, hit in May 2007. Macquarie Bank forecasts nickel to average around $11,023 in 2009, and Standard Chartered forecasts it to average $10,075.
While roughly 300,000 metric tons of nickel production was cut in 2008, which accounts for 18% of world supply, analysts say more cuts are to come and are indeed already occurring in the New Year. On January 20, major miner BHP Billiton said it is closing its Ravensthorpe nickel operation in Australia, which produced 14,000 tons of nickel last year. All these cuts, however, may not be enough to offset declining demand. ... Macquarie Bank estimates that 30% of total world stainless-steel production declined in Q4 2008, pushing nickel-market supplies into surplus.
Compounding nickel-price woes, stainless-steel producers are expected to use their existing stocks rather than set new long-term contracts, therefore delaying large nickel purchases. There are also reports that stainless-steel mills are still using nickel supplies bought in 2008 contracts for their 2009 needs ...
As a result, nickel demand is forecast to be flat at best in 2009, resulting in a surplus of 86,000 tons, versus a 36,000-ton surplus in 2008, says Calyon’s Bhar. “We will be lucky to get any stainless steel growth at all.”
When Will the Chip Industry Stop Seeing a Big Shadow?
What if Punxsutawney Phil were a chip analyst? I was wondering that last week as a wave of December-quarter semiconductor-earnings reports hit the tape. The numbers had few surprises. Over the past few weeks, chip and equipment companies had already engaged in mass confession. ...
The real worry heading into reporting season was not the actual Q4 numbers, but rather March-quarter guidance. And guidance is astonishingly bad. Chip makers are routinely forecasting sequential revenue declines of 10% to 20% or more. For many equipment companies, sales will be off 30%-plus from the December quarter, with a year-over-year falloff of 50% or more. Ergo, the chip makers – and the equipment makers who serve them – continue to chop salaries, cut jobs and close factories.
So, back to my friend the groundhog ... My original concept was to talk about how, if Phil were a chip analyst, he was likely to come out of his hole, take one look at the latest earnings reports, suffer an extreme case of nausea and retreat into the darkness to await a brighter day. But now I am thinking that what we really should be worrying about is not investors anticipating six more weeks of winter. Instead, I fear a scenario like Groundhog Day the movie, in which Bill Murray has to live the same day over and over and over. And over.
While it certainly might be tempting to think that things cannot get much worse from here – some chip analysts are trying heroically to pick the bottom – I fear that in a few months, we will relive the experience we are now enduring. March-quarter earnings will be as crummy as advertised. There will be more warnings, more layoffs and the occasional financial crisis. Then attention will turn to what horrors might lurk in the June quarter.
Some analysts have begun trotting out theories about why things could soon improve. In particular, the Street likes to point out that chip demand is even worse than PC and consumer-electronics end-market demand. That theory suggests that the system is soaking up excess inventory and that even a modest pop in consumer and enterprise buying could propel a healthy bounce in demand, lifting semiconductor and equipment stocks alike.
But I am not convinced. With the credit markets still shuttered, corporate IT demand in retreat, and consumers hunkering down, I do not see the Obama stimulus plan or anything else propelling a near-term recovery in PCs, mobile phones, routers, LCD TVs and other electronic doodads. And without that, it is hard to see a sustained recovery in chip or semiconductor equipment stocks.
I want to pass along some comments made last week by Lam Research (LRCX) CEO Steve Newberry on the company’s post-earnings conference call. Keep in mind that he is not some lunatic short-seller – Lam is one of the world’s largest producers of chip-making gear: “How long it will take before meaningful wafer-start expansion occurs is anyone’s guess, but we are expecting this type of environment to persist for at least the next six to eight quarters.”
Six to eight more quarters of this? If that happens, Punxsutawney Phil could end up with a lot of company in that hole.
Microsoft’s Misery May Last Awhile
Microsoft has apparently arrived into middle age. Yes, a down economy leads to lower PC sales and thus lower sales of Windows and other Microsoft software. But the maturity of the PC market itself and changes in that market mean that Microsoft will not be returning to its growth rates of old.
Microsoft and layoffs go together like oil and water. The company’s surprise announcement last week that it would initiate layoffs for the first time in its 34-year history is bitter medicine for the tech industry, especially for those being pink-slipped. Job security was certainly the least of their concerns when they joined the software giant.
“We are not used to down markets,” Chief Executive Steve Ballmer told analysts in a conference call. Microsoft reported earnings that missed analyst expectations. Shares closed at 17 on Thursday, down 11.7% for the day.
The workforce reduction is further evidence that this recession reaches much beyond the likes of Microsoft (MSFT), which has been one of the greatest growth companies in the industrialized world. The fourth quarter of last year produced the worst PC sales since 2002, with PC and laptop shipments falling about 0.5%, according to IDC, a technology research outfit.
Both consumers and companies are putting off their plans to buy new PCs or laptops because of the lousy economy, which bodes ill for Microsoft as well as chip maker Intel (INTC) and others in the supply chain. A hedge-fund manager who spoke with chief information officers at the recent Consumer Electronics Show says many are planning no desktop or laptop purchases in 2009, period. CIOs find that they can stretch out their usage for longer than three or four years, which has been the corporate upgrade cycle – until now. Plus, with hiring freezes and layoffs, there are simply fewer workers that need new machines, and unused computers can be reassigned.
Skeptics argue that personal-computer sales will suffer from more than just a sick economy. They say Microsoft’s expected rollout of a new operating system, Windows 7, later this year is not likely to spur an automatic hardware upgrade cycle like those in the past. The laptop boom of the past several years has armed consumers and businesses with enough computing power to last them for a while. In fact, most computers sold recently, with Windows Vista installed, have enough processing power, memory and configuration to run Windows 7, which received positive buzz at CES. Even our Wall Street Journal colleague Walt Mossberg, a known Windows critic, last week gave the beta version of the new OS a preliminary thumbs up.
In the past, it was nearly always necessary to buy a new computer to run Microsoft’s newest operating systems. Of course, the introduction of Windows 7 will initiate some new computer sales, especially among those who wanted to avoid the poorly received Vista. But Windows 7 is not likely to trigger hardware-upgrade cycles reminiscent of the past precisely because of its compatibility with existing machines.
On top of that, the emergence of sub-$400 netbooks – small laptops with enough power and memory to e-mail and to surf the Web – could also take a bigger bite out of future PC sales than originally expected. Most netbooks run on Windows XP, which is the predecessor to Vista and generates less profit for Microsoft than newer operating systems.
Sure, it is the economy’s fault, but the PC industry is undergoing changes that will outlast even the longest recession.
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