Fructivore Investments

The trouble with getting in on the ground floor of a new technology is that you never know how tall the building is going to be. Too many investors confuse technological brilliance with competitiveness, and a typical example of that is Rentech Inc.

On the whole I’ve never been too excited about technology for its own sake, and when I read a company profile that talks about improving chip interface architecture my eyes start to glaze over, which I think is a reasonable defense mechanism for an investor because there is a difference between knowing what a company literally does and knowing why they’re good at it (and more importantly whether their competitors might not become better at it). However, I was all excited about RYN and its black liquor processing, so it occurs to me that I like technology just fine, but not computers.

Rentech has a patented and proprietary method for turning synthetic gas (a mixture of carbon monoxide and hydrogen) into hydrocarbons usable for fuel, and synthetic gas apparently can be manufactured from ordinary waste. From the company’s overview in their SEC filings, they seem to make much ado of the fact that synthetic gas comes from urban and rural garbage, sugar cane refuse and other biomass, which gives them green credentials and also qualifies them for a grant from the Department of Energy  (unlike USEC which refines uranium using proven technology that actually is competitive and only wanted a loan guarantee but that is another story…). However, according to that same filing they have found that fossil fuels such as coal or petroleum refuse is more technologically complicated but seems to work better.

They have constructed a demonstration plant, and have made several attempts to demonstrate commercial viability, without success. Their primary source of funding has been issuing their own stock at a discount to whoever will buy it, which is not good for the shareholders but since the firm is not stable enough to sustain debt financing, there isn’t much else they can do. It explains why a company with a market cap of $300 million is selling at less than $2 a share right now. I don’t normally pay too much attention to a company’s price per share, but that is certainly anomalous. This year, they acquired, presumably using the proceeds of new issuance, an equity interest in a company that makes their feedstock out of cellulose, and acquired another that creates feedstock out of biomass, but it is not clear to me whether their main issue in commercialization is a sufficiently cheap source of feedstock or inefficiency in their own refining process.

Curiously, though, the company also owns a profitable segment: they use natural gas to produce nitrogen fertilizer. This Cinderella of a subsidiary supplies the operating needs of the company and also occasionally allows them to turn a profit (like last quarter, although it was the seasonal peak for demand of ammonia fertilizer). In fact, in 2008 if you neglect R & D expenditures, they turned a profit. According to Damodaran, research and development should be treated as a capital expenditure, rather than a flat expense, because it is not all money thrown away. In 2009 to date, Rentech have ratcheted down their R & D, but it seems to me that by acquiring these two new synthetic gas producers they have simply bought their research instead of doing it in-house.

So, this makes me wonder if we should turn it around; instead of a fuel refiner with a fertilizer segment slaving away to keep the firm afloat, perhaps we should look at Rentech as a fertilizer company with a parasitic fuel refinery. The refinery itself contributed $50 million year to date to operating earnings so far in 2009 (even after their supply contracts required them to pay an above-market price for natural gas, which the firm recorded as a loss), and $33 million last year. After $8 million year to date in interest, that leaves $42 million in pretax earnings, which would normally translate to $28 million in post-tax earnings but the firm is stuffed full of net operating loss carryforwards. With the firm’s market cap of only $330 million, that’s a P/E ratio of less than 8, which is good, right?

No. Unfortunately a parasite cannot be ignored, and given last year’s performance the nitrogen segment’s profits might be unsustainably good this year. I have been thinking of “real options” analysis, which is an attempt by finance professors to discover the next new thing, applying option valuation techniques to a company’s choices in its business plan. It may be said that we hold a profitable fertilizer company and hold an option on the future profitability of its refinery, but given the $60 million in R & D last year, and the $16.5 million plus acquisitions this year, it seems like this option has a high premium and seems constantly to be expiring and needing to be re-bought. And, of course, “we” the investor do not hold the option; the company management does and they seem to be very attached to it.  And, of course, there is their ongoing equity issuance, which dilutes ownership of the entire company, not just the refinery side.

Of course, if this refinery pays off the company should do very well by it, but I don’t know at what price per barrel of oil they will become competitive or whether that price has gone down or up in the last few years. If I had that information (perhaps the company could do something useful and commission a study that would actually figure this out), I would feel better if the price were something I could see happening in the near future.

But as things stand, I think a wise fructivore should take a pass. Buying into exciting new technology cheaply is always enticing, but better to wait for the technology to pass the “new” phase and into the “workable” phase.

Since I last proposed Callon Petroleum bonds, and following my success with the Bon-Ton junk bonds, I’ve been considering focusing more attention on this part of the market. Junk bonds, of course, offer massive yields, higher than nearly all dividend-paying stocks and certainly higher than normal bonds; however, defaults are a constant worry and the possibility of bankruptcy adds an exciting new aspect to investing. Moyers, in his Distressed Debt Analysis, warns that the small investor faces structural disadvantages as well, since bonds tend to trade blocks of hundreds of thousands of dollars at a time so the small investor has to pay a horrible spread. I suppose one correct call with Bon-Ton does not a guru make, but the more inefficient a market is, and particularly after the horrific price declines during that golden moment when the original purchasers realize for the first time that they’re holding junk, the more opportunities are available.

At any rate, consider Quiksilver, which makes clothes. Like so many companies, they have profitable operations but no actual profits because they are a friend of debt. But debt is not returning the favor. Of course, the acceptable debt level for a firm varies; the debt level that a utility would find quite bearable would strangle a manufacturer, for example, but when operating income is consumed entirely by interest payments and the shareholders get hardly anything, there is too much debt to make the equity look attractive. Of course, the academic financiers have argued that in an environment with income taxes and no defaults the optimum capital structure is 100% debt, and this discovery was apparently viewed as some sort of grand discovery on par with splitting the atom, although in terms of usefulness they may as well have told us what the optimum capital structure would be if the CEO were a unicorn (although this principle might explain why AIG is trading at a price above zero).

Getting back to Quiksilver, based on their current results virtually all their earnings are eaten up by interest and I am not convinced this situation is purely temporary, so obviously the equity of the firm cannot have any realistic margin of safety. However, the same was true of Bon-Ton stores. However, there is one worrisome aspect of Quiksilver versus Bon-Ton stores and that is on the balance sheet. Specifically, both of them have a senior secured bank line of credit that ranks ahead of its bonds. Although Ben Graham writes in Security Analysis that a bond investor is protected by the quality of the company rather than security interests and assets pledged, he was talking about investment grade bonds. Here, asset backing is probably worth a little attention in case something happens like being forced into bankruptcy.

In the case of Bon-Ton, the trade creditors (who in a bankruptcy are customarily given priority because their continued business is vital to the firm) and the secured credit together total a little more than the current assets, leaving the property, fixtures, and equipment available to cover the bonds. So, although this neglects asset shrinkage which often accompanies a bankruptcy, the fact is that $750 million in plant and equipment were available to supply a $600 million bond issue that was selling for less than $300 million when I posted the article (and actually dropped to $66 million at some point during the lifetime of the bonds).

But in the case of Quiksilver, the senior notes are also unsecured, and they also have a secured line of credit of up to 320 million in Europe, a 150 million privately placed note, also secured, and 20 million secured on a US line of credit, on which they have another 180 million available (which does give confidence in Quiksilver’s ability to ride out a further weak patch in the economy, but if they fail to do so it’s just that much more debt in line ahead of the bonds). So, about 500 million in secured debt are in line ahead of the notes, and on top of another 220 million in trade credit and some other debts, there are, say, 750 million in higher priority debts over the bonds, which eats up nearly all of their cash, receivables, and inventories. What remains is 75 million in current assets, 237 million in plant and equipment, and so the remaining 87 million in bonds is left to look to intangibles, goodwill, and “other.”

Now, intangible assets are not the same thing as nonexistent assets; they do represent capital and a source of excess returns, but the problem is that they are much harder to appraise, round up, and sell off. Of course, the $400 million in bonds is now just a hair over $300 given the bonds’ current price of 76 cents, but even without asset shrinkage there is no margin of safety in the bond purchase, unlike the $450 million in bond safety available from buying the Bon-Ton bonds at a price of under 50.

Yes, when junk bond investing, it is entirely possible to have to ride out a Chapter 11, which does itself only come after some truly buttocks-clenching drops in prices. So the reason you have to consider what piece of the firm is represented by your bonds is because there is not a trivial possibility that it will become an issue. And, of course, during the Chapter 11 itself interest on bonds is frequently suspended, especially for unsecured bonds. The reason to figure out security interests as well as priority in a Chapter 11 is because, even though secured creditors can be prevented from actually repossessing and selling their collateral, they are entitled to force the company to take steps to protect their secured property, including calls for additional payment, providing a lien on replacement assets (which is almost always done for inventory when it is sold and new inventory purchased, but they could even give a creditor with inventory as collateral an interest in the property and plant), and several other methods.

So, how did it come to pass that Bon-Ton’s bonds are backed by more assets than those of Callon Petroleum and Quiksilver? I think part of it might be the nature of the bonds. Bon-Ton’s bonds were issued in order for them to complete a large, expansionary acquisition, and the market realized the speculative nature of that expansion by giving them an interest rate of 10.125%. In other words, the bonds were junk and then became junkier. Callon’s bonds were perfectly well secured until falling oil prices and a couple of hurricanes caused them to take a huge writeoff, and even so their coupon was 9.75% representing the riskiness of the oil development in the Gulf of Mexico. Quiksilver’s bonds, though, were issued with a coupon of 6.875%, which is not indicative of junk and suggests that the company was considered a reasonably safe issuer that has suffered some deterioration over time, so their creditors were clearly not thinking about bankruptcy at all when they purchased the bonds.

So, although the massive writedowns of Quiksilver’s discontinued operations seem to have abated since the first quarter of this year, I’m not convinced that at this price the bonds represent an appropriate margin of safety, and with a current yield of 9% it’s not as if there aren’t better yields available elsewhere. But it never hurts to brush up on distressed and junk bond analysis, because sometimes in addition to getting all the earnings of a company, a skilled distressed debt investor can get a good piece of the company (which is to say, a piece of a good company) itself as a consolation prize from the Chapter 11.

Windstream has announced their fourth acquisition since they started, this time for  Iowa Telecommunications Services for 1.1 billion, consisting of 26.5 million shares of stock, $260 million in cash, and assuming $600 million of debt. The target firm has 256,000 access lines, 95,000 high speed Internet customers, and 26,000 digital TV customers, which the article mentions (perhaps with some prompting by Windstream) as the focus of Windstream’s current business plan.

However, it seems to me that this acquisition is unlike the other three purchases. In those cases, the price paid, if you indulged management’s optimism about synergies, and taking into account the excess of depreciation over capital expenditures, you still wound up with a price/free cash flow of around 10. Here, Windstream claims that about 8% of the purchase price consists of tax loss harvesting (which the Tax Code has very Byzantine rules about, but for 8% it is not the driver of the transaction so I wouldn’t be too worried).  But of the other 92%, I find that net income plus depreciation minus capital expenditures comes to an average about 50 million a year, which, given the $530 million paid for the equity is close to 10 but not quite there.

However, Iowa Telecom has also been a ravenous acquirer of other companies, and if we take those into account they eat up almost all the firm’s free cash flow for the last few years. It is possible that Iowa Telecom got what it paid for, but I am not entirely convinced. I would like to know if these acquisitions were motivated by necessity or strategy, since necessity places them more along the lines of a capital expenditure and therefore they would eat into free cash flow.

As for the assumption of debt, Iowa Telecom’s 600 million in debt was financed at fixed or variable rates that have recently run about 5-6%, representing an extra 31 million in cash flow to the firm. However, the lenders that made the financing provision made their deal with Iowa Telecom, not with Windstream, so rather than stepping into their shoes Windstream is going to have to refinance, and Windstream’s own interest rate, based on their latest private placement of notes, is closer to 8%. So, 387.5 million of that transaction can be financed from Iowa Telecom’s existing interest layout, but the rest of the debt, representing 17 million a year, will have to be financed elsewhere, and taking that out of the 50 million in free cash flow to equity (after taxes) leaves only about 38-39 million, for a price/free cash flow to equity of 13.8, which is worse than what Windstream had before the merger, and Windstream’s other acquisitions, provides. But at least Iowa Telecom is a public company so we can see the numbers for ourselves.

Windstream also claims that they will get $35 million a year in synergies out of the deal, and indeed they may. They were expecting a similar amount of synergy out of the Nuvox deal, which was smaller, so it could be more achievable in this case, but again, synergy is a thing that you believe in when you see it, because synergy is also the preferred method of the staff of acquisitive CEOs to make an unattractive deal look more attractive. And even when synergy does arrive when the acquisition and integration are sorted out, it may not be clear which acquisition it goes to.

So, to review, 80 million in free cash flow to firm, minus 48 million a year from the debt they take on and refinance, minus 21 million from the cash they paid (cash that could also be used to pay down debt), minus 26 million for the equity (from the dividends, but even without the dividends this is about their implied cost of equity), comes to minus 15 million, which has to be made up with “synergy.” I worry with this acquisition that Windstream’s management is more interested in building a bigger company than a better company. I would like to see them going through a trimming phase after this acquisition phase, where they sell off some of the properties or regions that are strategically unnecessary or financially weak. If not I may have to reconsider the attractiveness of the dividend given the safety of the firm. And their next acquisition really should be better than this one, for the sake of market perception.

If you have been following this blog for some time, you may recall the first move I recommended was the bonds of Bon-Ton Department Stores, which I suggested could be hedged by shorting an equivalent dollar value of the stock. At the time the bonds were at 46 and the stock was at $4. Now, the company has announced that they are not as doomed as previously thought, so the bonds have shot up lately to around 90 and the stock to almost 12. The bonds have paid their semiannual coupon since then, so they have properly speaking shot up to 95, but the follower of this move would have made $500 on the bonds and lost $800 on the short. I think that $12 for a company that is still having all of its earnings eaten up by interest is too high of a price, so these results have not diminished my enthusiasm for capital structure arbitrage (which is the formal name for this move), or for junk bond investing. Ben Graham wrote that even an unattractive form of investment, like a bond that is inadequately secured, can be attractive at an attractive price. Even though they are unlikely to appreciate past par, especially because most bonds these days are callable, they can still produce attractive returns.

However, the majority of junk bonds are junk for a reason, and they require careful screening. Consider the bonds of Callon Petroleum Co., which pay 9.75% and are trading at 60, currently yielding 16%. They fall due in December of 2010, but most of those bonds will never be redeemed, because the firm was forced to institute a tender offer because what with two hurricanes and a drop in the price of oil they were forced to discontinue a large operation in the Gulf of Mexico. Their other operations are barely able to cover their interest. The terms of the tender offer are  replacing the $1000 9.75% bonds with $750 13% bonds (thus actually saving nothing on interest), plus what works out to 37 ½ shares of stock. The new bonds fall due in 2016. The company is pleased to report that they have over 90% participation in the tender offer.

However, there is a small problem with their plan. Although the company is presently able to cover their interest, and possibly even with a few pennies left over for the shareholders, the firm’s long term strategy is in doubt. Unlike Linn Energy or Breitburn Energy, which focus on properties with a long development life, most Gulf of Mexico properties have a development life of only a few years, with most of the production heavily front-weighted. So, they have to acquire, explore, and exploit properties with considerable frequency. However, with no spare income and also no shareholders’ equity left (even with the bonds discounted and the nonrecourse debt from the discontinued operation moved off the balance sheet, they are below even), it is hard to determine what the company will use to acquire these new properties. They claim to be looking into longer-lived properties and joint ventures, and best of luck to them. Otherwise, they are potentially doomed beyond the assistance even of the Chapter 11 that they are trying to prevent with this tender offer.

As is often the case in distressed debt, the decision of whether to tender the bonds is a prisoners’ dilemma situation; if enough bondholders accept the exchange, the company will be able to redeem the non-tendered bonds without difficulty, so the holders who rejected the tender offer will make a windfall. But if not enough holders accept the tender offer, the company will be forced into bankruptcy. This is why, as Moyer wrote in Distressed Debt Investing, firms tend to require over 90% participation in any tender offer, a provision they can waive if necessary. Here, there is legitimately over 90% participation, so that hurdle is not an issue. Based on the current prices, apart from about $90 (discounted) in coupon payments due between now and the payoff date, the bondholder who rejects the offer is looking at $900 (discounted) for a price of only $510 per bond. This implies that even now there is an expected 57% chance of no recovery, assuming that 60 is also a fair price for accepting the tender.

The tender offer expires on Monday, and it is clear from the overall prospects of the firm, that it would be best to reject the tender offer and take our chances with the 2010 payoff. However, this firm does not appear to be another Bon-Ton stores, so the wise fructivore should consider a purchase very carefully.

The Greek word for marketplace is “agora,” so the word “agoraphobia” literally means “fear of the marketplace,” and Congress seems to be suffering terribly from it lately. Given what has happened over the last couple of years their reaction is unsurprising.

Indexing, long touted as the safe long-term option for the passive investor, has shown itself to be riskier than we all imagined, producing a negative 10-year return. If stocks always beat bonds over the long term, claim the authors of Dow 36000, then they are in fact less risky than stocks and thus the Dow deserves to be at 36000. If, however, they are more risky, then the index fund industry has some explaining to do.

Of course, after the dot-com collapse, the Nasdaq fell from 80% from top to bottom amid much less wailing, but I get the impression that there was a better sense of the speculativeness of those ventures, whereas the recklessness of financial institutions came as much more of a surprise. As Keynes wrote, “A speculator takes risk of which he is aware; an investor takes risks of which he is unaware.”

However, the response strikes me as excessive in some areas. Even though the the decision by the Fed to guarantee all commercial paper after the fall of Lehman Brothers was a stroke of genius (took in plenty of guaranty premiums without a single payout, not to mention saving the economy and I say that without exaggeration), we have to weigh that against Chairman Cox’s decision to outlaw short selling of financial stocks, which was a  knee-jerk reaction that demonstrated a fundamental lack of comprehension of market dynamics that one would not expect from the head of the SEC. In fact, in terms of ignorance it ranks alongside Alan Greenspan finding his “flaw.” Short sellers are a source of liquidity, and illiquidity in the face of panic selling produces a price collapse. Furthermore, shorts taking profits, which they certainly had in plenty last year, are a source of buying pressure that would mitigate the price collapse.

And what, may we ask, is so wrong with a price collapse? If the price drops and sets off a chain reaction of panic selling and margin calls, this will only push the price below even the most pessimistic fundamental estimates, at which point the sensible fructivores will start buying. It is the basis of all value investing, and we actually look forward to it. What distinguishes the commercial paper workout from the ban on short selling is that in the commercial paper arena what we were facing was a complete loss of confidence in the entire market, whereas the short selling ban was nothing more than an artless attempt to prop up prices. As an aside, I read somewhere that a CEO who blames shorts for the low share price of his company tends to give up on average 2% a month in share prices for the next year, and if the CEO blames a conspiracy of shorts, 4% a month.

So, apart from the fact that it’s the Baby Boomers’ retirement, what harm is there in coming to a sudden realization that the markets are riskier than we (most of us, anyway) all thought? Yes, too big to fail institutions are a problem and ideally should be broken up, or better still, forced to pay through the nose into an emergency liquidity fund to clean up the mess when they do fail. Beyond that, though, I don’t see what is the use of having measures designed to reduce volatility or the apparent riskiness of the market–and much of the effects of these measures will stop at appearance only. Optimizing capital structures using leverage does, it must be admitted, increase risk, but it also increases the amount of available capital in the economy, which is good for the GDP, and any mistakes normally work themselves out in bankruptcy court.

It is disturbing, though, that the regulators still embrace value at risk, which assesses the risk of loss on a financial asset by applying a stochastic process based on volatility that has been observed over a certain period, typically less than five years. Of course, the five years before 2008 were extremely boring in terms of volatility. Value at risk could perhaps be preserved if the period surrounding the collapse of Lehman Brothers was used as representative, but it would be quicker to abandon the stochastic myth, since security prices stop behaving as though they follow a stochastic process just about when panic strikes and every market participant wants them to be stochastic. In a book I read called Lecturing Birds on Flying, Pablo Triana suggests a Levy distribution, whereby events that are 6 standard deviations away from the norm may be predicted to occur every couple of decades instead of every couple of eons. I’ve never been that swayed by quantitative analysis, but if regulators are going to use a quantitative method they could at least use one that hasn’t been demonstrated not to work.

I suppose it is the embracing of the Capital Asset Pricing Model’s conflation of volatility and risk that informs much of the love of quantitative analysis. Volatility is neutral; by chance alone it can put prices in the wrong place, but exploitably and allowing for the likelihood of reversion. Risk is not neutral; it is negative and its effects tend to be more or less irrevocable, unexploitable for most people, and, of course, largely invisible. As an analogy for illustration, suppose that in a hand of Texas Hold’em, I have flopped a straight against my opponent who has flopped a set. There is about a 1/3 chance that he will improve to a full house or better. That is volatility. There is also an unknowable but nonzero chance that he will pull out a gun, rob everyone at the table, and vanish into the night. That is risk. But because it is hard to separate their effects during a the chilling moments of financial panic, Congress and the regulatory bodies feel bound to do something.

The latest proposal from the Senate Finance Committee is a plan to reorganize regulators, create provisions to split up banks that are too big to fail, and create a clearinghouse for derivatives. I agree that too big to fail should mean too big to exist, and as for the regulators, in my view whoever does the regulation is less important as long as they have teeth and the regulations are effective. However, I worry that stripping the Federal Reserve of its power over banks is just anti-Fed hysteria. My issue, however, is with the derivatives clearinghouse. The problem is that so many fancy derivatives these days are over the counter, which allows their terms to be customized. To trade via a clearinghouse, they would have to be standardized and commoditized, which might make them less useful. Furthermore, as happened with equity options and mortgage securities, these arcane instruments would be “domesticated,” and thus acquire an aura of safety and familiarity that is inconsistent with how bad of a mess they can make. Thus Congress, in an attempt to limit their impact by instituting these controls, may wind up causing them to expand, thus exacerbating the problem they intended to solve.

As some of you may recall, I called Coinstar an attractive short target some months ago, and it didn’t exactly go so well. In fact, it did go exactly as high as $38.28, when I called for the short at $25.91. Of course, that was during a massive stock market rally; one of the purposes of short selling is to reduce your exposure to broader market movements, which tends to work against you when you have short something that is highly correlated with the indexes during a rally.

However, with their recent earning announcement last Thursday/Friday, Coinstar very kindly gave up $3, dropping back to $29, and despite today’s rally they have regained none of that ground. And all this, despite beating analyst estimates for the quarter by a considerable margin. Of course, I’ve never understood the obsession with beating analyst earnings; if the company fails to beat the estimates the stock gets punished as if it’s the company’s fault rather than the stupid overoptimistic analysts’.

But as for Coinstar, it is true that they have increased their sales by $90 million since the same quarter last year, but do you happen to know by how much they increased their profits? Less than $2 million. So it is clear that we are dealing with a low profit margin firm, and now one that is facing increased competition from Blockbuster kiosks, as well as having to deal with Netflix and several antitrust suits that I don’t think they’re going to win. As I mentioned before, when Coinstar bought out its co-owners the price paid implied a value of $300 million for the entire Redbox division, and the counterparty was a sophisticated seller that had access to inside information, that probably concluded that the business was not likely to generate excess returns from any more capital put in, and based on these margins I am inclined to agree. Their other divisions have been more or less flat, so I remain unconvinced that this company is going to produce the kind of growth that will justify their still-optimistic valuation.

Accordingly, I continue to short Coinstar and suggest that the rest of you, if you do short, short this one too.

P.S. I couldn’t miss out on this little gem from the conference call. From seekingalpha.com

“We closely track consumer satisfaction by measuring our net promoter scores. As you can see on slide five, we continued to hoverer [sic] north of 80%, which puts us with such companies as Apple, Google and Amazon.com, iconic brands that have been established over a much longer time.”

http://seekingalpha.com/article/171699-coinstar-inc-q3-2009-earnings-call-transcript?source=yahoo&page=2

Yes, I suppose they are comparable to Apple, Google, and Amazon.com…in this small and almost completely irrelevant aspect.

Windstream (WIN) has just announced that they are acquiring yet another phone company, NuVox, for 280 million in cash, about 180 million in stock, and 180 million in assumed debt, total 640 million. 

NuVox focuses specifically on business, which makes it a desirable fit with Windstream’s plan to offset landline loss with high revenue customers. NuVox claims to produce $115 million in “adjusted” earnings, the adjustment being to smooth out nonrecurring charges and to put $80 million in depreciation and amortization back in. So, as adjusted the purchase has a P/E ratio of 5.6, but eliminating depreciation and amortization charges is an old trick invented in the 80s to make mergers and buyouts look more attractive, and it didn’t work then. And yet, most phone companies have depreciation charges that exceed their capital expenditures so not all of the $80 million may have to be put back in. Of course, since NuVox is private I have no concrete information to work with. Windstream also claims that the combined firm will have $30 million a year in synergy, but for synergy the wise investor says “I’ll believe it when I see it.”

In addition to being a good strategic fit, management claims that the acquisition will be accretive to cash flow. Accretiveness to cash flow is the easiest thing in the world: just buy a company with a lower P/E ratio than yours. And, if you put all the depreciation back in and indulge management’s view of $30 million in synergy, (canceling one optimistic assumption with one pessimistic one about depreciation), you get a P/E of 11, which is a little bit below WIndstream’s unadjusted trailing P/E ratio, but of course Windstream’s cash flow is significantly higher. So, the actual accretiveness is up in the air.

In terms of strategic fit, I keep thinking back to those Fairpoint rumors. Fairpoint had a market that was almost completely unsaturated with profitable high speed services, and their intention was to fill that gap in the market, thus earning sufficient profits to pay off the ridiculous debt they took on to make the purchase. Of course, they were too busy dealing with integration issues to make any headway, forcing them into bankruptcy. With this acquisition, much of the penetration work has presumably been done, thus making Windstream’s post-merger work easier, but also entitling NuVox to a premium in its purchase price.

In the final analysis I am neutral towards this merger, since unless the depreciation is in fact greatly in excess of the capital expenditures I’m not convinced that Windstream is getting anything that hasn’t been paid for in full.

As I stated yesterday, American Lorain has announced that they have sold stock and warrants totaling 5 million shares for $2.40, 1.75 million shares worth of warrants at a price of $3.70 that become exercisable six months after the transaction closes and have a term of 5 years thereafter, and 500 thousand shares worth of additional warrants with the same terms except that they only run for two and a half years, all for the price of $12 million.

As anyone can see, though, $12 million is simply 5 million shares times $2.40; the warrants seem to have been thrown in for free. These warrants, which are essentially call options, according to the Black Scholes formula using a high volatility assumption, and based on $3 a share, are worth $1.16 and 76 cents respectively. Now, of course writers smarter than I ( as well as less smart) have criticized the Black Scholes, since it is inaccurate for valuing options that are long-dated or far from the strike price and is based on an unrealistic view of asset price behavior, but it is undeniable that the warrants are worth more than nothing. In fact, I believe the consensus is that the Black Scholes tends to undervalue such options, in which case this was definitely a poor arrangement for American Lorain. And, since I think the company was undervalued before the deal was finalized, this price is even more indefensible.

Of course, since I think that a price of $5 is minimally adequate for the company, I see it more that the firm has just given away more than $1 per warrant. I can only assume that the price was negotiated around a month ago when the stock was trading at less than $2.40, since at $3 before the announcement it seems like a ridiculous deal.

Even going by market prices, at $3 a share, the company loses 60 cents times 5 million shares, $1.16 times 1.75 million in the 5-year warrants, and 76 cents times 500 thousand in the 2-1/2-year warrants, total $5.41 million. Before the deal was announced, the firm was trading at  $3 a share with 25 million shares outstanding, total $75 million. After the announcement yesterday, the share price dutifully retreated to $2.70, total market cap $67.5 million. It fell further today, of course, but what didn’t?

Now, the company will receive $12 million from the sale proceeds, but be diluted by 5 million additional shares. If the warrants are not exercised, there will be no further dilution, so ($75 million plus $12 million sale proceeds – $5.41 million in discounts), divided by 30 million shares, comes to $2.72 a share.

If the warrants do get exercised, as I think they will be, the company takes in an additional $3.70 per warrant, or $8.325 million, at the cost of further dilution. It also suggests that the share price of $2.40 was an even bigger discount, so I’ll just use the warrant price of $3.70 instead of $3 (for making this modification I am relying on no financial authority but myself, but it seems to me to have a certain logic). So, (75 million + 12 million + 8.325 million – 5.41 million in old discount – 3.5 million in new discount)/32.25 million shares comes to $2.68. So, with the warrants exercised or without them this new equity offering has diluted the company by 30 cents a share.

(It is curious, though, that the closing price $2.69, settled right between the above-calculated diluted values; I would never imply that the markets are efficient, but at the very least they are paying attention).

Si Chen, the firm’s CEO and majority shareholder (at least for now (unless he has an interest in the buyers of this offering in which case some shareholder derivative lawsuits would be in order, so I doubt this is the case)), is “very pleased with our ability to acquire this type of equity financing given the nature of the tight global markets. It speaks well of how the investment community views American Lorain.”

However, since the firm’s P/E ratio was 4.67 as of yesterday, this represents a cost of capital of 21.4%. Although I commented before on the high interest rates they get in China, the worst one in their last report was a “mere” 13.1% and curiously their cost of long-term financing is much lower than their short-term financing (although there could be subsidies at work; I’m not an expert on China’s internal investing environment). Of course one expects the cost of debt to be less than the cost of equity, but this year’s earnings to date are on par with last year’s,  and last year their interest payment was covered 7.5 times; it was covered 6.2 times the year before that, and year to date it is covered 4.5 times for a company that claims to see higher demand in the second half of the year. This coverage ratio, although not iron-clad, is consistent with investment-grade credit and it seems to me that raising the capital by borrowing, even though the firm would be pushed to the lower end of investment-grade, would be preferrable to giving up 8% in cost of capital and submitting to dilution.

Nor, to my knowledge, has American Lorain stated what they intend to do with the proceeds. As of last year their return on assets was 15.3% and their return on equity was 23%, so at a 21.4% cost of capital even if they did realize these results from their new capital (which is questionable because of diminishing marginal returns) they hardly produce any benefit that would justify this level of dilution. Even paying off their debt would significantly improve their already fairly strong credit profile.

Accordingly, I think this offering was entirely ill-priced, and should constitute a black mark on the market’s perception of the talents of American Lorain’s current management.

As some of you may recall, I suggested getting out of Capstead Mortgage (CMO) on the grounds that its fat dividend (currently 17%) couldn’t last forever and that, at a price of $14.60 and a book value per share of $11.50,  the price represented well over a year of excess dividends, and the Federal Reserve is not likely to keep interest rates low for that long.

Now, the price has fallen back to $12.80 as of yesterday and $13.30 as of today. However, their latest report indicates a book value per share of $12.20. However, the principal value per share is, I believe, sitting at around $10 per share, since adjustable-rate mortgages tend to keep their value in over time the face of interest rate movements and these are explicitly guaranteed by the US government, thus producing a nice premium over principal value. The principal value is important because mortgages are prepaid at their principal value, and last quarter Capstead Mortgage’s prepayments were running at a 23.5% annual rate. The prepaid securities can be replaced, but at the same premium which, based on the latest results, is 3.5%.

At any rate, $13.30 set against an unmodified book value of $12.20 is only six months’ of excess dividend, which seems to be long before the Fed will consider raising rates  (even though the economy is officially growing again) and even after interest rates rise, as long as they stabilize in a reasonable range Capstead Mortgage will be able to earn reasonable, if not their current outsize, returns. However, the mob in the marketplace will probably react to a diminution of the dividend as a sign of disaster, selling until the stock represents no premium at all, or even a discount, to book value. As I stated before, that is the time to really pile on Capstead Mortgage.

P.S. I know that American Lorain has just made a potentially dilutive equity offering. I’ll collect my thoughts on the matter and let you all know.

Well, it’s official: Fairpoint has filed for bankruptcy. As Moyer’s Distressed Debt Investing states, the actual filing of a Chapter 11 is never a surprise. Although it may seem curious that its creditors reduced the size of their claim from 2.7 billion to 1 billion, the reality is that the creditors are going to become the beneficial owners of Fairpoint no matter what the size of their claim. In fact, most bankruptcies involve some pre-filing negotiations of this type and it is rare but not impossible that these early maneuvers obviate the need for bankruptcy, although they did not in this case.

I still haven’t seen anything to confirm the rumor that Windstream is buying up Fairpoint’s debts in order to carry some of Fairpoint’s more lucrative operations. But I will repeat the necessity of caution; buying more than one could afford was what killed Fairpoint to begin with–how anyone can expect a telephone company to pay off a debt at 13% interest is beyond me.