Fructivore Investments

Hugh Hendry, the hedge fund manager and inflation skeptic whose views I have always found informative and interesting, sat on a panel at a conference last February called the Russia Forum. I finally found footage of the full panel. On the whole, he was his usual opinionated self, but he did shed some light on the China situation. Although the remarks are months old, I think his views are entirely applicable today.

The panel, chaired by Marc Faber, consisted of himself, Nassim Taleb (author of Fooled by Randomness and The Black Swan), Michael Gomez of Pimco, David North of General Investment Management, and Michael Powers of Investec, were asked whether or not China is a bubble. Nassim Taleb, in his usual style, said that if people were looking for the “hot” growing country to invest in in 1900, they would have picked Argentina before the United States and so things are really only obvious in hindsight. Hugh Hendry, more willing to put his sense of pattern recognition where his mouth is, answered a definite yes.

His grounds were that a nation that is simultaneously a large foreign creditor and running a trade surplus comes to a bad end unless one or the other of those things changes. It creates a massive asset bubble that ultimately leads to a deflationary depression. China is in that situation now, he says. Japan was in that same situation in 1990, and, strange though it is to think of the United States as a creditor nation, it was in that same situation in 1929.

Of course, correlation does not imply causation and this could all be an interesting coincidence, but the proposed mechanism makes it a plausible hypothesis. Obviously a nation that is a large foreign creditor and that has a large trade surplus winds up with a huge amount of cash bouncing around its economy beyond what it requires domestically. This creates a pressure on the extra money that should push it back out into the world, as the people of the country spend it on foreign goods and services. Ultimately, this turns the trade surplus into a trade deficit fairly rapidly. If, however, this natural process is obstructed by economic forces or explicit government policy, that money has nowhere to go except into pumping up domestic asset prices.

Although it is further back in history than Hendry would go, Spain and Portugal had a similar problem. Adam Smith records that because of their possession of the very productive gold and silver mines of their American empires, massive amounts of money flowed in. However, mercantilist ideas of the time equated the wealth of a nation with the amount of gold and silver in it, and so the countries banned or imposed an export duty on the two metals. As a result, Smith writes that Spain and Portugal were “the two most beggarly countries in Europe.” Adam Smith likens this process to building a dam; if you dam a river without altering its course in any way, the water will eventually overflow the dam and keep flowing exactly as it did before; there will just be created a lake of liquidity deep enough to drown in.

In the United States, Hendry claims that the gold standard prevented that money from going abroad (and much of Europe at the time had little for the US to purchase), a situation that a modern floating exchange rate would prevent. China, of course, does not have a floating exchange rate. In fact, not only does China use a fixed rate, but it actually forces its exporters to surrender their foreign currency in exchange for yuan at the government’s official rate. That money ultimately winds up in the hands of China’s central bank, which adds it to the bottomless pot of foreign reserves. The alternative, as I stated, is that the exporters could use that money to purchase foreign goods and services that they might actually enjoy. Hendry provocatively describes this policy as turning Chinese citizens into worker ants, and it results in the Chinese working for less than they’re worth, and forced into overpriced real estate, all to feed the current account surplus. He seems to think of it as a financial imperial ambition where China is placing financial global influence over economic stability.

Evidence suggests, though, that this ambition of China is rapidly becoming more trouble than it’s worth. China has (very slowly) been trying to allow the yuan to appreciate, and last August also began to allow exporters to keep some of their  foreign currency holdings offshore, where they would not have to be converted. Be that as it may, asset bubbles are called bubbles, rather than balloons, for a reason. With balloons, the air can be let out in a gradual and controlled process, but bubbles only burst.

Given the fact that China’s is inevitably doomed if they continue their policy, I still don’t know how to respond to Obama’s call for China to liberalize its exchange rate policy. It may be part of a Sir Humphrey-type grand strategy, where Obama is calling for China to liberalize its exchange rate in the hopes that it will force them to dig in their heels and not do it. On the one hand, the principle of self-determination must mean that China has a fundamental right to destroy its economy however it pleases. Furthermore, it would be nice to see one of the United States’ rivals for global supremacy to suffer a setback, and it might result in some recovery of manufacturing in the United States. But on the other hand, recessions have messy unforeseen consequences, and I’m not sure that China would handle widespread civil unrest very well.

Either way, I recall that in the 80s people were worried that Japan had somehow managed to repeal the ordinary laws of economics, when all they had really done was set the stage for a lost decade. One would have thought our own experience with bubbles would have left us more alert for other peoples’.

As you may have noticed, the stock market has been doing very well over the last few months, and even my staid old telecoms have been caught in the updraft despite (or perhaps because of) the high dividend payouts. As the entire market now seems to be looking for yields now that cash and most fixed income (not my junk bond recommendations) have anemic yields, and the general trend seems to be for companies to do something with their excess cash other than making capital investments (Qwest has been eagerly buying back its debt), the recent advance in Qwest is unsurprising. Now, many of the talking heads have begun to question whether the rally is stalled and we should all get out (a sure sign that the rally is likely to continue). However, in my view the value of Qwest and CenturyLink have crossed a key valuation threshold.

As I said in my last article about how CenturyLink (then CenturyTel) was buying Qwest for less than its fair value, I calculate Qwest (Q) to be worth about $13 billion based on applying a multiplier of 10x to its average five-year free cash flows to equity of $1.33 million. CenturyLink’s five-year average flows are complicated due to a recent spate of mergers, but I would think that $800 million, or an $8 billion value for the pre-merger company, is not out of the question. The companies estimate that they will gain about $500 million in synergy from the deal, which, capitalized at a multiplier of 10x again, comes to $5 billion. So, $13 billion + $8 billion + $5 billion comes to $26 billion. The combined market caps of Qwest and CenturyLink are now $24.9 billion, within spitting distance of this price.

Now, it is not unusual for a company to swing from below fair value to above it, and so I may see a higher price for Qwest in future. But as a value investor, I am satisfied with buying below fair value and selling at fair value, because at that point there is no advantage in continuing to hold an investment. Furthermore, the case for $5 billion of that value is from synergy, which represents a dangerous assumption.

As was shown in Damodaran’s Investment Fables, an important book that examines the true historical performances and other concerns about various investment strategies, mergers have a mixed record when it comes to enhancing value. The book cites a study that assessed mergers along two lines: 1, Did the return on the amount invested in the merger exceed the acquirer’s cost of capital?, and 2, Did the combined company outperform the competition? Of the 58 mergers studied, 34 failed at least one test and 28 failed both of them. Furthermore, Damodaran concluded that firms that acquire  companies of a similar size has a worse record than firms that acquire smaller firms. In the case of the CenturyLink/Qwest merger, the target, Qwest, is actually bigger than the acquirer by most fundamental measurements. However, the book also claimed that firms that merge to gain economies of scale have statistically greater success than firms that merge to keep their growth streak going in order to impress analysts, which is to be expected. At any rate, it appears that actually realizing synergy from a merger is more difficult than managements and investment banks would have us believe. Therefore, conservatism demands not counting the full value of the synergy (or perhaps even not any value at all) to the combined company.

I cannot say for certain that this current price ($6.93 as of today’s close) is the best price I can get for Qwest (there is, after all, a $1 billion discrepancy between the market cap of Qwest and CenturyLink that will theoretically have to be resolved as the companies are merging roughly as equals), but I can say that it is about the highest price I feel comfortable in getting. As is suggested in Marty Whitman’s Value Investing: A Balanced Approach, sometimes the merger and acquisition market overtakes the ordinary investor market, and we have to take what we can get. In this case, then, the current price of Qwest is about as good as we can get without running the risk of overvaluation and the possible risk of loss that comes with it.

I am pleased to report that my habit of finding investment opportunities that come in pairs is running true to form. I recently recommended the bonds of the Mohegan Tribal Gaming Authority, and now I can follow it up with the bonds of the River Rock Entertainment Authority, which runs a casino in Sonoma County, California, which offer reasonable safety and an unbelievably high yield.

The bonds currently trade at around 84, with a coupon of 9.75%, current yield of 11.7%, and fall due in November of 2011, offering a yield to maturity of roughly 30%. The bonds’ credit rating is B+, ostensibly an improvement from the CCC+ debt that I normally seem to find. The bonds are River Rock’s only long term debt, which prevents us from worrying about issues of subordination or secured versus unsecured. As stated in Steven Moier’s Distressed Debt Analysis, a vitally useful book for investors in junk debt, if there is only one bond issue it is automatically senior and secured.

The issue size is $200 million, and at current prices has a market value of $170 million. The question, then, for the bond investors, is simply whether the entire casino is worth less than the value of these bonds. As we shall see, the financial statements of River Rock indicate that this question is ludicrous.

Revenues at the casino have been on the decline as the economic troubles have been underway, but seem to have stabilized. The casino’s operations have not only covered their interest requirements by a significant margin, but have also allowed the generation of a substantial profit.

In 2007, income was $139 million, operating expenses net of depreciation were $88 million (including an $11 million “credit enhancement fee” to their developer, an obligation that has since been extinguished), producing operating income of $51 million. The gap between depreciation and capital expenditures was $3 million, creating estimated free cash flow of $54 million. Their interest requirement of $21 million was thus covered 2.57x, a safe margin considering the rating of the bonds.

In 2008, income was $140 million, operating expenses net of depreciation were $76 million (the fee owed the developer is conspicuously absent), producing operating income of $64 million. The gap between depreciation and capital expenditures was $4 million, producing operating income of $68 million, which covered their interest requirement by 3.3x. This level of interest coverage is may actually be found in the lower levels of investment-grade debt.

In 2009, income was $124 million, operating expenses net of depreciation were $70 million, producing operating income of $54 million. The gap between depreciation and capital expenditures was $4 million again, producing estimated free cash flow of $58 million. Their interest requirements were covered 2.76x despite what was apparently a difficult year.

In 2010 year to date, income was $65 million for the first two quarters, with operating expenses of $35 million, producing operating earnings of $30 million. Plus a $1 million gap between depreciation and capital expenditures, we have $31 million in operating incomes, with interest covered 2.95x.

You can see what I mean by the absurdity of the question of whether the entire casino is worth less than the bonds. In its worst year, the casino could boast $58 million in free cash flow to the firm. The value of its debt, $200 million, then, is less than four times its yearly free cash flow, a remarkably safe proposition. (By way of comparison, Bon-Ton department stores bonds, another junk bond I liked, had a debt/free cash flow ratio of about 10 when I bought it).

So, then, what is the source of the market’s skepticism? Most value investors have given up on determining why the market does what it does, but identifying the factors is still worth considering. First of all, there is a proposal to build a new casino between River Rock’s current location and the San Francisco Bay Area. River Rock reports that this casino is still in the planning and permitting stage, but if it is ultimately approved and built, it would perhaps affect River Rock’s profitability in a few years’ time. This fact might make it difficult for River Rock to refinance its bonds in November of 2011. Furthermore, River Rock reported in its 2009 10-K that its plans to renovate and expand have been put on hold for want of financing, which no doubt is weighing on the market perceptions as well. Also,  the casino transfers at least $11 million to the Tribe every year, and these payments, although they rank below the bonds in priority, might well be regarded as sacrosanct. However, this distribution is well covered by the casino’s operations after interest.

I think the main reason, though, is that the balance sheet is apparently not in good shape, containing a large entry for “construction in progress” and showing hardly any equity at all even taking the construction in progress into account. However, earnings power should guide the balance sheet, not the other way round. The casino also has $35 million in cash on the books, so it may be that River Rock will not have to roll over the full amount.

Moreover, in the unlikely event that River Rock were unable to refinance these bonds, the market would be in uncharted territory, as no Indian casino has ever tested the bankruptcy courts. Obviously, the traditional workout of the bond holders stepping up to become new equity holders is unavailable because only an Indian tribe can hold an interest in an Indian casino. However, the alternative of foreclosure and liquidation is not feasible, because the property is useful only as a casino, really, and given its current profitability there would be no reason to pursue this course. So, as no stakeholder in the casino has any reason to see its operations terminated, even in the unlikely event that the debt could not be rolled over, a workout would ultimately be fairly painless.

So, based on the above figures I can state that River Rock gives every appearance of being able to handle the interest on its current bonds and give assurance to the new debtholders when the time to roll the issue over comes that they can service their debts. As a result, I think the large discount and consequent high yield to maturity are a market anomaly that will likely be corrected, to the profit of everyone who buys at the current price.

I was involved in a conversation recently about short selling, where the old adage was trotted out that a stock can rise to infinity but only drop to zero, which is said to illustrate that short selling is more risky than investing on the long side. Although this is technically true, its impact on the risks of shorting has perhaps been overstated. Obviously, stocks can make large moves in short time periods where there is not enough liquidity to allow a graceful exit, but that applies to downside moves as well as upside. The real issue comes from the possible  asymmetry. As a result, a good short candidate should not have that asymmetry in place, and so a lot of short selling horror stories may come from stocks that were poor short selling candidates to begin with.

The example that was raised to me was a small biotech company that announced over the weekend that it had cured cancer. The announcement turned out to have been a gross exaggeration, but anyone short in that position would have had a very bad day. Likewise, shorting low-priced stocks (below $2, $3, or sometimes even $5 or higher) also run the risk of asymmetry. The reason for this effect is that startup companies or many low priced stocks tend to be have like call options, or bets on whether the company will achieve profitability before it runs out of financing. Of course, such bets are often losers, but shorting such a stock is putting oneself in the position of being short an option rather than a stock, and without even taking in an option premium. So, rather than shorting a low priced stock for pennies and hanging on for the bankruptcy, it would be preferable to short a high priced stock that the market has unjustifiably run away with.

In that vein, I am pleased to offer Crown Castle Industries (CCI). Like SBA Communications, it is a cell phone tower company, and again like SBA Communications it is under a heavy burden of debt and generating a free cash flow that is inadequate to justify its $12.36 billion market cap.

I will first deal with the free cash flow issue. As I have stated, a decent proxy for free cash flow is reported earnings plus depreciation minus capital expenditures. In Crown Castle’s case, reported earnings have been negative, although they have lately been approaching zero but for nonrecurring or arguably nonrecurring events. As they seem to be constantly refinancing their debts, they have reported refinancing losses which I am willing to treat as not related to their core operations. In the last few reporting periods, Crown Castle has also reported losses due to ineffective interest rate swaps. Although this is technically part of their financing strategy and should be treated as recurring, the firm has been reducing the size of their interest rate swap positions and so I could justify treating it as nonrecurring.

So, taking out noncore or noncash items, in 2007 they reported earnings of -$222 million, after $540 million in depreciation, $24 million in amortization of financing costs, $66 million in writedown charges, $75 million in impairments, $25 million in acquisition integration costs, and $300 million in capital expenditures (and $494 million paid for an acquisition, which I’m not counting), producing total estimated free cash flow of $208 million. However, $94 million off that $208 million consists of tax benefits, which, as they do not technically have any taxable income, becomes a net operating loss carryforward. Because they still have no reported profits, the company may not realize the value of their carryforwards for some time, and it actually does not represent immediate cash flow. In that same year, the company incurred interest expenses of $325 million, producing an interest coverage from free cash flow to the firm of 1.64x.

In 2008, the figures were -$49 in reported earnings plus $526 depreciation & amortization, $25 million in amortization, $17 million in writedowns, $56 million in impairments, $2 million in acquisition costs, minus $451 million in capital expenditures, producing $126 in estimated free cash flow, of which  $104 million is tax benefits. Interest paid that year was $330, producing interest coverage of 1.38x.

In 2009 the company was able to ratchet back its capital expenditures somewhat. The figures were -$114 reported earnings plus $530 million in depreciation, $91 million in losses from refinancing, $61 million in amortization, $19 million in writedowns, minus only $173 million in capital expenditures, producing free cash flow of $414 million, of which $76 million was tax benefits. Interest paid that year was $332 million, producing coverage of 2.25x.

Year to date 2010, they reported earnings of -$217 million (owing to a large loss on interest rate swaps), plus $267 million in depreciation, $66 million in losses on debt refinancing, $37 million in amortization, $4 million in writedowns, plus $187 million on the swaps themselves, minus $91 million in capital expenditures, producing estimated free cash flow of $253 million, of which $15 million is tax benefits. The same figures for the first two quarters of last year were $207 million in free cash flow of which $56 million was tax benefits. Most interesting to me, though, is the fact that in the same period, interest expense rose from $146 million last year to date to $208 million this year to date. Interest year to date is covered 2.22x, and the remaining cash flows produce a price/free cash flow of about 30. This strikes me as high for a company with such debts, particularly one with slowing growth.

Now, I did notice an interesting point in one of their filings, that their maintenance capital expenditures were only $10 million a year. I have noted before that, as stated in the useful Damodaran on Valuation only maintenance capital should count against free cash flow, because growth capital can be suspended at any time (presumably at the expense of the growth it would create). However, it is not clear that management is aware that they are in a financially precarious situation and so they may go on gleefully expanding their capital into oblivion. Furthermore, it strikes me that $10 million may be their current maintenance requirement, but that figure may go up dramatically. If many of their towers are of fairly recent vintage, it may be some time before wear and tear start to take its toll, but when it does capital requirements may increase in a hurry.

Sales have been increasing at a fairly steady 10% for the last few years. Operating income plus depreciation and nonrecurring events moved from $665 million in 2007 to $838 million in 2008 to $983 million in 2009 to $534 million for the first half of 2010, or $1068 million on an annual basis. This indicates to me a slowing rate of growth. Even assuming that interest takes precedence over capital expenditures, interest coverage has moved from 2.05x in 2007 to 2.54x in 2008 to 2.96x in 2009 but dropping back down to 2.62x for the first half of 2010 owing to higher interest requirements. It may be claimed that cell phone towers are in the nature of a utility company and can bear a lower interest coverage ratio, but the increased interest expense for 2010 suggests to me that some of their lenders are starting to become worried. The company announced that subsequent to their latest figures they issued $1.55 billion in debts to replace $1.33 billion in tower revenue notes (albeit at an interest rate 1.2% lower), which, like SBAC’s, are held in a securitization-type arrangement.

Crown Castle may be a bit further from breaching its covenants than SBA Communications, but it is not out of the question. The covenants in their credit agreement require that their adjusted EBITDA/total debt must be less than 7.5, and that their EBITDA/interest must be at least two. I don’t know what “adjustments” they are making, but they report that their adjusted EBITDA/total debt is 5.7 and their interest coverage is 2.7x, which is a little higher than I calculate it. Curiously, according to Etrade, its bonds trade at a premium despite yielding only 5% for the 2015 bonds and about 5.9% for the 2019 bonds, and a credit rating of B-. This is only anecdotal, but I’ve noticed that all the bonds I like are rated CCC+, suggesting that the credit agencies might consider them worth of a higher rating but aren’t willing to stick their neck out by pushing them up. I think the same reasoning could apply to a B- rating on the downside. At any rate, though, their calculation and mine is before Crown Castle’s capital expenditures, which take another bite out of actual cash flows.

So, it is my considered opinion that Crown Castle is in a bind. Its growth is slowing, requiring it to make high capital expenditures in order to grow into its current share price. However, it is bumping near the ceiling of its debt capacity, and funding capital expansion out of its own cash flows reduces free cash flow to shareholders. As a result it looks as though Crown Capital is too overextended one way or another to justify its valuation, making it a potentially attractive short.

I read in the news today that on the second anniversary of TARP, the government has earned 8.2% on its investments in banks and insurance companies, which comes to about 4% a year. The article claims that many investors expected the deal to have losses running into the billions, which I suppose is true, but I’m not sure that these results vindicate the program. After all, in order to know how well it went we have to compare it to private bailouts.

Consider the CIT group bailout; in July of 2009, after the government announced that it would not receive a second round of TARP financing, it was forced to look for salvation elsewhere. It found it in a group of bondholders that included Seth Klarman, noted value investor, and the terms were much better for the lenders than 4%. They required an interest rate of LIBOR + 10%, or 13%, whichever is greater, plus a security interest amounting to 5 times the amount of any borrowing, plus a dizzying array of fees: 5% for any amounts lent, 1% per year for any amounts not lent, and 2% exit fee. Although CIT group was unsuccessful in avoiding bankruptcy, the loan company made out all right; because of their security interest they would receive every penny of principal owing to them including interest after the bankruptcy filing.

For another example, in September 2008, Warren Buffett purchased from Goldman Sachs $5 billion in preferred stock that yields 10% per year, plus warrants–stock options, basically–to purchase $5 billion in Goldman Sachs common stock at a price of $115 a share. Goldman Sachs currently trades at $157 per share. Of course, that deal was put into place before anyone knew that TARP would pass, but in those two years Warren Buffett has made $1 billion in dividends plus about $1.8 billion in intrinsic value of the warrants. That’s a return of 24.9% per annum over roughly the same period that TARP has produced 4%.

Of course, these deals are the cream of the crop when it comes to bailouts, but when I look at them I still can’t help feeling a little shortchanged when it comes to TARP.

As anyone who holds Seagate (STX) knows, or at least has had the opportunity to investigate upon seeing the price jumping by 16% overnight, there has been news of a buyout offer from TPG Capital and Kohlberg Kravis Roberts to take Seagate private at a price of $7.5 billion, or about $15.88. So, this naturally gives us holders of Seagate the dilemma of taking our profits now or seeing how this will turn out.

Now, this offer is below the 52-week high of $21.58, and furthermore, I calculated earlier that the firm is in a position to generate roughly $1 billion in cash per year, so a price of $7.5 billion produces a multiple of 7.5x, which seems low. $21.58 is a multiple of about 10.2x, which strikes me as more reasonable. Although hard drives are commoditized and theoretically under pressure from solid state drives, if most investors require a 10% return on their money a multiple of 7.5 implies some pretty substantial declines in future earnings power. However, it cannot be denied that the market has not been able to sustain a higher multiple for Seagate, and private equity/buyout firms require returns substantially upwards of 10%. So, which market do we rely on?

In considering this question, I am reminded of Marty Whitman’s book, Value Investing: A Balanced Approach. whitman’s book argues that value investing has moved beyond Graham & Dodd fundamentalism, which I find a highly controversial point. I think he sort of cherry picks the parts of Security Analysis he chooses to disagree with, but his theory of value investing is that traditional approaches to investment are solely concerned with the outside passive minority investor market, where individuals and institutions trade small pieces of the company back and forth. Although basing valuations on this market is a useful skill, Whitman’s thesis is that there are other markets that the complete value investor has to be aware of.

For example, he talks about how Benjamin Graham advises bond investors to assure themselves that all of a company’s bonds satisfy high standards of safety, and then buying the highest yielding one, which is typically the subordinate issue. However, Graham elsewhere states that a deterioration in the company’s performance can cause a troubling decline in value. Whitman, though, completes the thought by concluding that the decline in value matters in the bond traders’ market but perhaps not in the holds-bonds-to-maturity market, who are less likely than the bond traders to use leverage and therefore can sometimes afford to ignore market prices. And, if the deterioration should become severe, the relevant market is the post-Chapter 11-workout market, where the senior, rather than the subordinate, issues are likely to be the more desirable purchase, and, if even in bankruptcy the senior debts will receive 100% of their claim plus accrued interest, the prices in the actual bond market don’t matter. This is quite the postmodern approach, taking into account a market that doesn’t exist yet.

Relevant to the situation with Seagate, though, is the difference between the outside passive minority stock market and the buyout market. In the time of Benjamin Graham, of course, a leveraged buyout was not in anyone’s vocabulary and the perception was that an investor could purchase an undervalued stock and take all the time in the world to wait for the stock to reach fair value, at which point it could be sold, invariably to another investor. However, the introduction of the leveraged buyout (or the merger, liquidation, etc.) can cut this process short, so investors’ exit strategies must include the possibility of taking what they can get. Fortunately, buyouts typically (but not always) come at a substantial premium to the current market price, but unfortunately the market price can still be below the “fair” price, so an investor can still be left without full value.

I do recommend Whitman’s book, as it gives a unique and intriguing perspective on the art of value investing, and contains such witty commentary that only an investing veteran could produce, such as (paraphrased) “Predicting future earnings per share is a job that any competent analyst can do (although accuracy is a different matter). But turning that into a future price requires predicting future P/E ratios, and that is something that can only be done by an expert in abnormal psychology.” And “Among the disadvantages of running a public company, #1 is the exposure to a swarm of litigious idiots, i.e. public shareholders.”

So, where does that leave us with the Seagate decision? On the one hand, the buyout value does appear low, so it might be worth hanging on to in case the offer is rejected or, ideally, a bidding war breaks out, in which case hanging on to the stock would be wise. On the other hand, the buyout negotiations might fall through, as a previous buyout for $7 billion did, and the price might fall and be a long time in recovering. On the third hand, it is customary in buyout negotiations for the Board to insist that the acquirer bump up the price somewhat, so that in the inevitable shareholder derivative suit they can claim that they did serve the interests of the shareholders by demanding a better price, so the $7.5 billion could conceivably go up even absent another bidder.

So, again, what should we do? Well, not having any prophetic abilities, I don’t actually know what we should do, but I can tell you what I have done, which is selling off half of my position. I won’t turn up my nose at a quick profit, but I am also willing to wait for a slow one, at least for now, as I believe Seagate to still be worth upwards of $7.5 billion in both the stock and the buyout markets.

I observed before that the stocks I like come in pairs, and having found Entercomm, a radio broadcaster that went through a difficult 2008 and 2009 and whose operations now seem to have stabilized but at an attractive price. I believe that with Saga Communications (SGA) I have found a paired company.

Saga is a smaller company, with a market cap of only $87 million and an average daily volume of only 6000 shares (most days there are only a few trades, some days there are none at all, but the volume is definitely skewed to the upside). The lack of liquidity of this stock may make it unsuitable for many investors, because some care and trading skill may be required to build a position or, more importantly, to exit it if the market becomes volatile. However, the patient long-term investor who can ride out any volatility spikes may expect to be rewarded.

As with Entercomm, Saga Communications had a difficult 2008 and 2009, which resulted in them incurring significant asset impairments. This caused them to book a GAAP loss for the two years. Revenues were lower in 2008 and 2009 than in 2007, indeed, but the impairments themselves were a noncash expense. If we reverse these transactions as nonrecurring, the company’s operating income went from $27.9 million in 2007 to $24.7 in 2008 to $18.7 million in 2009, although fortunately the firm’s operating expenses scale down somewhat alongside their revenue. They have been paying down their debt at a fairly rapid pace, $30 million in 2009 and an additional $8 million year to date. This paying down of debt, plus the fact that their loans are variable rate, has served to reduce their interest requirements from $8.9 million in 2007 to $7.2 million in 2008 to $4.9 million in 2009. Their interest coverage ratio, then, has never dropped below three times. I should also point out that their depreciation expenses have run a few million dollars below their capital expenditures, which is normally a source of free cash flow. However, their current capital expenditures are below historical levels, so it may be better not to count on the additional cash flow. After deducting interest and applying a 35% tax rate, we have earnings of $12.35 million for 2007, $11.37 million in 2008, and $8.97 million in 2009.

For the first two quarters of 2010, advertising revenues have recovered somewhat and are about 5% above where they were for the first two quarters of 2009, and whatever cost containment the firm has been putting into play has been continuing, as their operating expenses are lower than in 2009. The net effect is that they have $11.4 million in operating income, as compared to $6.3 million last year. Interest expense came to $3 million, and removing that and 35% for taxes produces $5.5 million in earnings, or $10.9 million on an annualized basis, which is a fairly attractive earnings yield of 12.5%. Furthermore, the firm states that the first quarter brings in the lowest advertising revenue, so the full year’s results may be a little better.

Under the term of Saga’s credit agreement, the available balance on their line of credit is reduced by $2.5 million each quarter. I’m not sure if I should count this figure against free cash flow or not. On the one hand, it is money that must be set aside for the benefit of creditors rather than shareholders, but on the other hand it seems pretty clear that the firm should be paying down its debts aggressively anyway, since the credit agreement comes up for refinancing in 2012, and at any rate earnings belong to the shareholder no matter what the company subsequently does with them. The firm estimates that its excess cash flow, as defined in the credit agreement, will come to $8.3 million for the year. Presumably, the company has an incentive to define excess cash flow to be less than the full amount of earnings, but it is comforting to see that the company is not projecting a diminution of revenue that would result in an inadequate earnings yield.

The risk, of course, is that come 2012, or earlier if they start encroaching on their covenants, they may have to refinance their debt at a higher interest rate. However, they are generating an adequate return on their money, they have over $200 million in book assets against $96 million in long term debt, which is being paid down. Therefore, it seems to me that the risk of interest rates becoming high enough to put the company and its earnings ratio at risk is a remote one.

As a result, I can recommend Saga Communications as a medium/long term investment for anyone who can deal with the low level of liquidity. Just be careful getting in or out.

I have been greatly interested in junk bonds over my investment career, as they offer some potentially very attractive returns and often without correlation to the broader bond or equity markets. However, I have found that because junk bonds are considered as an asset class best left to the professionals, the literature available on them is small compared to the size of the asset class (particularly since the asset class grows during difficult economic times). Fortunately, though, in Leveraged Financial Markets, edited by William Maxwell & Mark Shenkman, we who are unafraid to build our own high yield portfolios have found a valuable resource. Whether we want to construct a full high yield portfolio, or just if we take my approach of buying single issues opportunistically, the book has much to assist us.

The book’s editors take the Frank Fabozzi approach, whereby instead of writing the book themselves, they solicited articles from experts in the particular field: the section on debt covenants was written by a partner at Cravath Swaine & Moore, a premier New York law firm, and other sections likewise written by experts in their fields.

One of the key pieces of advice is that it is impossible to make a portfolio that beats the target index under all circumstances. Certain types of bonds will do better in a recession, and other types of securities will do better in a neutral or growth situation, and because of the liquidity in the bond markets it is impossible to switch one’s approach without incurring greater costs than the profits from the new approach. This is common sense, but it puts me in mind of my own value investing approach. The goal of an investor, professional or personal, should not be to beat an index; it should be to finish up with more money than we start with, without taking undue risks. And, as I stated above, those of us who invest for ourselves have our choice of asset classes and can act opportunistically, as opposed to someone constrained to run a junk bond portfolio, have the advantage in this situation.

In terms of actual analysis, they provide some very useful advice, the most important of which is to adopt a highly fundamentals-based approach and above all not to rely on credit ratings. Even before ratings agencies had to back away from the ratings they issued because of the tsunami of CMO defaults, they have taken great pains to remind users that, although a BBB credit is better than BB, they cannot translate a rating to a default probability. Although the book refers us to a number of services that perform statistical analyses to identify defaults before they happen, my preferred approach is to find junk bonds that are actually robust to defaults. At any rate, the authors also remind us of concerns broader than default risk of a single issue, such as the health of the sector and also the level of liquidity in the market. At any rate, the key advice of the book is to analyze credits yourself, rather than rely on a credit rating agency to do it. This is vital advice; my favorite credit rating seems to be CCC+, and although most CCC+ bonds I can still reject as unsuitable, I would throw away a whole family of B rated bonds to find a CCC that offered the right risk/reward situation. The authors also remind us that a high yield cannot compensate for unpalatable risk; a junk bond investor cannot afford to assume that his or her portfolio holdings insure each other.

I have to say that my faorite part, though, was the discussion of covenants, and not just because it was written by a lawyer. Covenants are not even mentioned in Graham’s Security Analysis, since prior to the 80s deep consideration was deemed unnecessary because only creditworthy companies were expected to issue debts anyway. And, of course, before the junk bond crash of the early 90s no one quite grasped their importance. Afterwards, the bond community decided that it was necessary to take covenants beyond their historical course. As the book details, junk bond covenants are now greatly detailed, including restrictions on use of loan proceeds, restrictions on issuing new debt and even interest coverage ratios, in order to protect holders from small problems becoming large problems leading to bankruptcy. In fact, my short recommendation on SBA Communications was largely based on the possible impending breach of their covenants.

In short, anyone who is interested in junk debt, or even companies that issue it, would do well to have a resource like this one at their disposal.

I have been interested in short ideas lately, and the last two I identified, Red Hat Inc. and Concur Technologies, were demonstrably overpriced and already showing signs of running out of growth. However, there was no catalyst lurking in the wings that had the potential to throw a wrench into the market’s optimism. However, with SBA Communications (SBAC) I think I’ve found a company which, in addition to slowing growth, is also staggering under a large and growing burden of debt. If their debt covenants are breached–and they are already under pressure–it could definitely serve as the desired catalyst.

SBA Communications owns or leases a number of wireless communications towers, and leases space on them to wireless service providers. Their revenues have been increasing, but they have been continually expanding their portfolio of towers through the issuance of debt. Because of the large amounts of depreciation that their business generates, they have no actual earnings. Their free cash flow, although positive, is showing slowing growth. Wireless traffic in the United States is also on the rise, which would explain the optimism surrounding this company, but the debt of this company appears to me to be approaching a dangerous level.

The company’s earnings figures are complicated first because depreciation is much greater than capital expenditures, which is a common enough occurrence. But the true earnings power of the company is also occluded by noncash interest expense and gains and losses from bond redemptions. Not only has the company had to resort to increasing debt levels in the first place, but it has also had to get creative in the form of its debts; they have three outstanding convertible issues as well as a securitization-type structure whereby they have transferred some of their tower holdings into a special purpose vehicle and securitized the income from them.

I have spoken before of how certain convertible bonds produce non-cash interest expenses; accounting rule ASC 470-20 now requires them to be divided into a debt component, as determined by the estimated value of a non-convertible bond paying the same coupon, and an equity component consisting of the value of the conversion privilege. The equity component is considered paid-in capital and is amortized over the lifetime of the convertible instruments. I have said previously that, instead of increasing the clarity and information content to the user of financial statements, this rule decreases it. The borrower is not on the hook for only the debt value of the instrument when it is issued; it is on the hook for the full amount, and the company is forced to recognize interest payments that do not exist to amortize paid in capital that never existed. The phantom interest distorts the earnings calculation, and a user who is unfamiliar with the application would easily be induced to undervalue a target company. Furthermore, the amounts are not updated alongside stock price and volatility, and linear amortization also does not correctly model the behavior of options. In SBA’s case, the application of this accounting method actually reduces the stated amount of their liabilities from $2.549 billion to $2.386 billion.

Fortunately, I am somewhat conversant with ASC 470-20 (and SBA lists the nonexisting interest separately on their income statement anyway). So, we can calculate their free cash flows once we adjust for this noncash interest and depreciation and capital expenditures. We should also adjust for the nonrecurring profits and losses from their continuous extinguishment and reissuance of debt. In SBA’s case this is often a significant amount: in the last three full fiscal years they have issued $2.57 billion in debt (not counting $182 million in warrants and $375 million in options to reduce the effect of the conversion features, which it seems to me would defeat the purpose of issuing convertible debt) and paid back $1.42 billion in several transactions.

In fiscal year 2007, free cash flow after all the above adjustments was $87.540 million; in fiscal year 2008, $122.078 million; in fiscal year 2009, $140.573 million, and year to date 2010, $70.911 million as compared to $77.402 million for the first half of 2009. The serial growth, then, is 39.5% for 2008, 15.2% for 2009, and -8.4% year to date. If we annualize the year to date cash flows, we get a price/free cash flow ratio of 32.6, which seems high for a company with a slowing growth trajectory. Revenues increased 16.4% between 2008 and 2007, 17.0% between 2009 and 2008, and 11.5% for the first half of 2010 as compared to 2009, so there is an apparent slowdown there too.

Now, the price/free cash flow ratios for our other shorts were somewhat higher; Concur Technologies was 102, and Red Hat’s was 67. However, neither of those companies are hampered by a large and increasing burden of debt. SBA, on the other hand, has a very weak interest coverage ratio: 1.94x times in 2007, 2.16x in 2008, 2.07x in 2009, and 1.95x year to date, which is typically consistent with a credit rating in the B- area. The company’s current credit rating is apparently BB-, but according to Etrade that hasn’t been updated since July 2009. The face amount of their long-term debts is $3.06 billion, but they are carried on the balance sheet at $2.81 billion (owing mainly to the convertible discount above), plus other miscellaneous debts, produces a total liability of over $3.14 billion, set against $3.43 billion in book assets. Of course, the high levels of depreciation has made the stated asset values unreliable, but it is still not an attractive picture.

But what leapt out at me was SBA’s credit facility, which requires that they have on an annualized basis, a debt/EBITDA of less than 5x, an EBITDA/cash interest of greater than 2x, and a debt/adjusted EBITDA of less than 8.9x. The company claims to be in full compliance with these provisions, but it occurs to me that they may be cutting it close. I have already calculated an interest coverage ratio of less than 2, and their actual debt/EBITDA on a year to date annualized basis is 10.77. Presumably, this apparent breach is cured by the securitization arrangement; the revenues and income from the securitized towers are consolidated for reporting purposes but not for the purposes of the credit facility, as they are in a special purpose vehicle and are nonrecourse anyway.

Unfortunately, we do not know what amount of revenues and cash flow are offsetting the interest requirements of these towers, but the firm claims that they meet the required 1.3x coverage of the securitization agreement. The debts issued by the securitization entity have a weighted average coupon of 4.6%, which, out of $1.23 billion in face value, is $56.58 million, or $14.1 million per quarter. Multiply by $1.3, and we get $18.4 million per quarter that is the minimum “reserve” from cash flows to comply with the terms.

So, carve out $1.23 billion in debts, $14.1 million in interest payments, and $18.4 million in securitization entity cash flows, and we are left with parent-level quarterly cash flows of roughly $58.8 million, interest payments of roughly $23.3 million, and total debt of $1.91 billion. This represents interest coverage of 2.5x and debt/EBITDA ratio of 8.1x. So it is pretty clear that the SBA is bumping up on the edge of their covenants. I should point out that the company has no borrowings on its credit facilities at this time. (I am also aware that the way I’ve written this test, the greater the share of securitization income, the lower the cash flows of the parent company are, but since the majority of the securitization’s cash flows are pledged to the debtors anyway, not very much of the income can be counted in favor of the parent company, at least until the notes are paid down somewhat).

So, although it seems that the market is willing to accept SBA Communications with an overall interest coverage ratio of 2, it would also appear that the company’s growth is decelerating and any actual diminution in the company’s current earnings would put them in a difficult situation covenant-wise. Furthermore, even if wireless traffic does expand, SBA may not be in a position to take advantage of the expansion without the ability to acquire more capital freely as necessary. This, coupled with decelerating growth, suggests to me that SBA is an attractive short candidate.

I have previously expressed an optimistic view on American Greetings (AM), based on its attractive price/free cash flow. Last Wednesday, American Greetings announced earnings that were substantially down from one year ago, and the stock was punished by nearly 10%, although it has recovered somewhat since then. Now, Ben Graham reminds us not to place too much weight on the results of a single quarter or even a single year; nonetheless, nonetheless, it may still be worthwhile to examine the results of a quarter for signs that the company can no longer produce the desired performance. If, however, the company can continue to produce results, the market’s overreaction may create profitable opportunities.

American Greetings reported a decline in revenues of 3.8%, or about $13.6 million; however, it explains this away as the result of the sale of their party goods division, without which sales would have declined by a mere 1%, which I think of as a trivial difference. More significant is the decline in reported earnings from $23.1 million to $8.5 million. Prior to the announced results, American Greetings had a market capitalization of over $800 million, so if we take the $8.5 million as fully representative of their earnings power, annualize it, and then apply a multiple of 10x, we get $340 million. This is a slight gap.

American Greetings’ management first cites that these earnings contain $5.2 million in expenses to integrate two recent acquisitions, while last year’s earnings for the quarter were increased by $7.9 million in insurance benefits. I consider both of these to be nonrecurring. Removing them serves to considerably narrow the gap between the two years. A second issue is that the firm’s tax rate for the latest quarter was the unusually high figure of 49.9%. If we remove the integration costs and apply a kosher 35% tax rate, we get $14.4 million, which is much closer (although it is still not the $20 million that would produce our $800 million market capitalization).

However, we are leaving out on our favorite adjustment, that of subtracting capital expenditures and adding back in depreciation. This measure improves estimated free cash flow to approximately $17 million, which is very close to our target. American Greetings’ management also understands the importance of free cash flow; their metric they cite in the announcement and earnings call is cash flow from operations minus capital expenditures, and they claim that they have produced $75 million out of their target $120 million for the year. Much of that amount comes from changes in working capital and is therefore not likely to be recurring, but for the first half of the year, earnings as modified above plus depreciation minus capital expenditures still comes in at $51 million, which is actually an improvement over last year.

So, although I would have liked the $17 million estimated free cash flow for the quarter to have been closer to the $20 million I had in mind, it is clear that overall performance has not degraded. So, absent further declines, American Greetings is still attractively priced, and the 10% drop seems to me to be more the effect of market participants seeing a large GAAP earnings decline and not digging any further into the numbers.