Prediction: BP vs. Drillers

I have now been asked by many different people about the valuation of BP.

My response to them is the same as before: “I would not bother thinking about this [buying shares] until BP has cut their dividend.”

However, I will offer up a prediction:

Over the course of the next 2 years, $10,000 invested in BP (NYSE: BP) at the closing price of June 16, 2010 will under-perform $10,000 evenly invested in Transocean (NYSE: RIG) and Noble (NYSE: NE). Assume dividends are not reinvested and remains as zero-yield cash.

The analysis of BP has converted from a financial/resource calculation to purely a political risk calculation. The current US administration is very adverse towards their non-donor constituents and while BP has donated scalds of money to the Democratic party in 2008, it is very likely they will still be made into a scapegoat for the Gulf of Mexico oil spill.

I am very interested in the drillers, and I am waiting for one more “shoe” to drop before likely placing some bids. Implied volatility on Transocean would suggest that selling near-the-money put options is a viable strategy for entry, but I am waiting for a price drop before executing on that. This also goes outside of my “don’t invest in companies outside an English-speaking jurisdiction” rule, but there are times to make exceptions and it seems to be close to one.

I also notice that Canadian oil sands companies are getting quite a bid – I am guessing capital is flowing into the politically safe Alberta oil sands. Suncor and Cenovus are the big players here, although there are a couple interesting bitumen plays that have a smaller capitalization worth looking into.

All of these oil investments assumes an implicit risk that the price of oil will at least be stable or preferably increase.

When will the Lulu bubble burst?

People in and around the Vancouver area are probably quite aware of Lululemon, a marketing firm that sells retail apparel. Most people would consider them to be a retail apparel firm, but I would dispute this classification.

I have been watching this company since it went public, not because I ever intend to buy shares in the firm (or their clothing), but rather because it is a Vancouver-based business that has been insanely profitable and has done an incredible job permeating amongst my own age demographic.

Although I have very little intuition about fashion, I have studied the industry extensively and currently have some money where my mouth is in the form of a stake in corporate debt of Limited Brands (one major holding they own is the branding to Victoria’s Secret).

This morning, Lululemon reported their first fiscal quarter results. While I am less concerned about them beating or missing analyst estimates (they exceeded them) my focus is on their gross margins – 54% for this year’s quarterly result. This is a high gross margin for an ordinary clothing manufacturer, so they are adding much value on the marketing side and thus having their customers pay more for products that otherwise would cost the same to make.

Gildan Activewear, for example, has a gross profit of around 28% in their last quarter.

If you look at other firms to benchmark Lulu with (of which I will use Limited Brands, Abercrombie & Fitch and Nike) – Limited’s after-Christmas quarter reported gross margin of 36% (which includes “buying and occupancy” costs), while Abercrombie’s gross margin was 63% (strictly on “cost of goods sold”, not including store and distribution expenses), and Nike’s is 47% (albeit for the Christmas quarter, but their yearly results are comparable to this). If you were able to drill into the numbers and make them on an equivalent basis (which is not very easy to do when mining the details of the company’s detailed quarterly reports that they externally report), the profitability of Lululemon is not that much higher than equivalent (i.e. “high-end”) and established US corporations.

So looking at a relative valuation basis, you now have the following (not factoring in Lulu’s recent quarter):

LULU – Market cap $2.8 billion, TTM revenues $453M, net income $58M; (cash: $160M, debt: $0)
LTD – Market cap $8.0 billion, TTM revenues $8.84B, net income $558M; (cash: $1.7B, debt: $2.8B)
ANF – Market cap $3.1 billion, TTM revenues $3.01B, net income $90M; (cash: $633M, debt: $71M)
NKE – Market cap $34.8 billion, TTM revenues $18.65B, net income $1.73B; (cash: $4.0B, debt: $0.6B)

This very brief comparison gives me the belief that Lululemon is being valued as a marketing company (like Nike) rather than an “high-end retail” apparel company (like Limited and Abercrombie). It is also much, much differently valued than a “commodity clothing” firm like Gildan (which does not have a direct retail presence).

The most cursory glance at the financials would lead one to believe that if you were to believe that LULU was a “buy” at the moment, they would have to grow, considerably, into their valuation even to make it comparable to Nike’s valuation level. Assuming a “steady state” valuation of 20 times earnings and/or 2 times sales, you would have to extrapolate Lulu growing their top line at 30% a year for roughly 5 years with the share value being roughly the same as it is now.

Even though in the last quarterly result they grew their top line 70% over the previous year, it is very difficult to swallow a company’s shares thinking that they have an implicit requirement to grow their sales from $450M/year into $1.4 billion just to cut even. Will they do it? Who knows. But the level of baked growth makes the stock look very risky for the reward offered – if they have one misstep, they will see a 2008-style haircut. It won’t be nearly as bad as the 90% cut from the 2007 highs, but it will be considerable.

British Petroleum and the drilling companies

I have done nothing other than look at the summary financial statements of BP, but on paper they look undervalued. The mess in the Gulf of Mexico, however, will be costing them considerable amounts of money. I’ve projected a couple years of earnings ($40 billion) that will likely go down the tubes as a result of this environmental incident.

The market will take BP down to the point where nobody will expect, and when everybody has written off the stock, that is usually the time to buy. In essence, this is a psychological play, so it involves more game theory than financial analysis since it is likely that BP will remain a continuing entity in the future. Their balance sheet is fine – about $40 billion in debt and $7 billion in free cash flow ($20B income) in 2009, so they won’t be facing any solvency issues.

The better question is whether one should invest in the drilling companies. It is likely lease rates will drop since offshore drilling will have significant demand drops and the market has already been pricing this in. As an example, Transocean has also been slaughtered.

I generally do not look into companies that are not trading in Canada or the USA, and BP is a British company, so I will not be considering them seriously. However, the other companies (e.g. the aforementioned drillers) I will be investigating. Since there are so many eyeballs on this sector, there must be other circumstances (e.g. panic) that would be required to ensure that you are getting good value for your investment. It is also exceedingly difficult to predict when to catch the falling knife and the investment to invest in BP is essentially that – you need to place your purchase orders when everybody has gotten their hands so bloodied up trying to catch the knife that they have given up trying.

I would not bother thinking about this until BP has cut their dividend.

Apple vs. Microsoft

It was only a couple months ago that I wrote about how Apple and Microsoft’s market capitalizations are closing in on each other.

Today, Apple for the first time has a market cap higher than Microsoft, at $222 billion for Apple and Microsoft at $219 billion.

The real issue with the two companies is that Microsoft is really living off of its legacy product lines (Windows and Office) while Apple has come out with a huge stream of technological innovations, mainly the iPod and iPhone product lines (which secretly get the users to lock into their business model, similar to how software in the 90’s was “for Windows” only).

At this time, I don’t see how Microsoft can demand a market premium for its position – on the retail end, Windows has not fundamentally changed in 15 years (Windows NT 4 was the quantum leap product, and Windows XP was a great retail refinement of the Windows NT core). Microsoft Office has not fundamentally changed since the release of Office 97; everything else subsequent has been cosmetic in nature. With competitors chipping away at the cost premium that Microsoft charges (typically to large-volume corporate licensees), their ability to extract margin out of the marketplace with upgrades and obsolescence upgrades is limited. Microsoft will continue to produce cash like no tomorrow, but it is tapped out in terms of growth. Microsoft shares, as a result, trades like it – analysts expect $2.31/share in FY2011, while the stock price is $25.01/share – a yield of 9.24%.

Apple, on the other hand, has plenty of room to invade the computer marketplace, and combined with their mobile device market seemingly can command a high premium and has room to grow. As a result, they are given a premium in the stock market – analysts estimate $15.42/share in FY2011, on a stock price of $244.11/share – a yield of 6.32%.

Although Apple has competitive issues (i.e. Google is trying to invade the territory), it remains to be seen whether it can keep Google and other competitors at bay. Certainly its marketing arm continues to create users that have an almost religious-like adherence to its products.

I don’t have a position in either company and don’t plan on establishing one.

The impact of touting a stock

Jim Cramer is very well known to anybody in the financial domain as a former hedge fund manager, but also a hothead on CNBC television hosting a daily show called Mad Money, where he praises and pans every stock on the book. He knows, and the audience should know that his show is purely for entertainment value (Cramer is really an excellent host that seems to never run out of his child-like adrenaline surges), but a whole bunch of amateurs take him seriously.

It used to be when his show came to the air that whenever he made recommendations that the stocks would go up, significantly, in after-market trading, only to recede to their previous levels a couple days later. Traders would usually target this phenomenon and try to capture the demand by short selling and taking profits later.

If anything, it was a very fascinating exercise of how sharks try to eat fish, akin to a poker game – that type of stock trading was definitely zero-sum, and Cramer had the ability to attract a lot of amateurs that were also trying to make the fast dollar off of each other. It was undeniable that in the first few months of the show, Cramer had the ability to move stocks and somebody was probably able to consistently take advantage of it (e.g. being associated with somebody directing or producing the show, for example).

So it was with interest when a fellow named Controlled Greed, who has 5,514 subscribers according to Google Reader, on May 22 mentioned that he took a position in the previous week some illiquid smallcap company (XETA). It has a market capitalization of 39 million and an average volume of 6,700 shares or roughly $25,000 traded a day.

Most notably, on no news, the stock opened up Monday about 5% on 1900 shares. So his article did attract a few market buyers, which I found to be fascinating.

My econophysical studies of situations like these suggest that “immediate popularizations” of stocks has an impulse function effect on the share value, but the value of the impulse declines substantively as the value of the popularization exponentially decays, and eventually reaches a null point (where it is indistinguishable from background noise) a few days later (the decay rate being variable). But you have to wonder how many of those 5,500 readers now stick XETA on the watchlist, waiting for some sort of substantive news. I will not. One of my rules is that by the time you read about any obscure stock pick on any popular medium, it’s already too late.

Volatile week in the markets

The markets, reeling off of last week’s volatility spike, started up Monday massively when the European Union did their trillion-dollar backing/bailout. Then later in the week, the market began to sober up again.

It is difficult to know whether the markets will continue to be volatile or not, but last Friday’s trading action took everything down for reasons that are not entirely clear other than volatility and presumably a drive to safety.

I did not perform a single transaction last week, but continue to watch intently whether there is anything worth picking up. I still don’t find anything trading below a value worth considering and thus will continue to be patient. I get sufficiently rewarded by waiting and thus am not in a hurry to deploy cash.

I do note at present that the risk-free pre-tax long-term rate is around 3.9%, and if you asked me to cobble together a portfolio that would give a relatively stable and long-term income stream, I could probably make a balanced portfolio with enough diversification that would give around 7% in about half interest income and half eligible dividends over the next 20 years. Such a portfolio would be roughly half long-term corporate debt, quarter preferred shares and quarter equity. Stable income does not equate to stable capital, however – it would be highly sensitive to rate changes, and opportunity for appreciation would be limited. At least it would beat inflation.

Valuing Western Financial Group Preferred Shares

Western Financial Group (common: WES.TO) is primarily an insurance brokerage in Western Canada. They have been able to grow their top line consistently over the past few years, while their bottom line, although profitable, has fluctuated with the market. It is likely they will continue to be making money in the future, so payment of debt and preferred securities should not be an issue, barring any huge global financial crisis.

They have an issue of preferred shares (series 5, WES.PR.C) that has the salient details:

$100 par value, 9% coupon, payable semi-annually;
Holders can convert into common at $2.81/share anytime;
Issuer can convert if common is $3.79/share or higher after September 30, 2012;
Issuer can convert if common is $2.81/share or higher after September 30, 2014.

As I write this, the common is trading at $2.87/share and gives a 4.28 cent annualized dividend (1.49% yield). The preferreds are illiquid and the bid-ask midpoint is $113/share.

To value this preferred share, you must break down the fixed income component and the embedded call option that you (a preferred shareholder) sell to the company.

The fixed income component is simply [coupon / (share price / par value)], which in this case is 7.96%.

The more difficult valuation is with the conversion component. This creates a few scenarios, and note that we assume we sell the common shares immediately after conversion:

1. If the common trades above $3.79/share on September 30, 2012;
2. If the common trades above $3.79/share between October 1, 2012 to September 30, 2014;
3. If the common trades less than $3.79/share after September 30, 2012, but trades above $2.81/share after September 30, 2014.
4. If #1, #2 and #3 do not apply and if the common trades less than $2.81/share after September 30, 2014 until X date.

Scenario 1 is fairly easy to calculate – if you anticipate this happening, you really should invest in the common shares rather than the preferred shares. If the common stock ends up at $3.79/share on September 30, 2012, you will essentially be receiving $135 of value for your preferreds, plus 5 semi-annual coupon payments. A $113 investment will result in $135 in capital gains, plus $22.50 in coupon payments over a 2.40 year period. Annualized, this works out to a 7.69% capital gain, plus a 7.96% income yield. This is contrasted with a common stock performance of 12.3% capital gains and 1.49% income yield (assuming no dividend increase) over the same time period.

In this event, the preferreds seem to be the better investment, especially when seniority is considered. If the common shares go higher than $3.79/share before 2.4 years, the returns between the preferred shares and the common will be proportionate.

Scenario 2 will result in the same absolute return, but depending on when the threshold common stock value is reached, it will result in the same absolute return in terms of capital, but the annualized yield will be less because of the extra time taken to reach the conversion threshold. As an example, if $3.79 is reached on September 30, 2013, the preferreds will have an annualized capital gain of 5.37%, and an income yield of 7.96%, while the common will have a capital gain performance of 8.52% and income yield of 1.49%.

Scenario 3 – assuming the common stock does not go anywhere (i.e. stays at $2.87/share) for the next 4.4 years, a common share investor will receive a 0 capital gain and 1.49% income yield; the preferred holder will receive a 6.4% capital loss on conversion (annualized will be 1.42% loss), but retain an income yield of 7.96%. There are multiple variables at play – when the conversion price is reached and what price occurs at September 30, 2014. For a 10% increase in common share value above $2.81, the preferred shares’ effective value on conversion also increases by 10%, but is capped to 35% when $3.79 is achieved.

Scenario 4 involves a loss – in this event, the fixed income nature of the shares will be more apparent and the conversion privilege becomes less valuable. A common shareholder will lose more capital than the preferred shareholder.

At a value of $113/share, the value of the common shares needs to be $3.18/share in order to avoid a loss of capital upon conversion. This is approximately 11% above the current common share price, but the preferred share holder is compensated for this by the higher coupon payment – they would receive payback for this difference in about one and a half years of coupon payments.

As such, somebody interested in Western Financial Group should be better off buying their preferred shares rather than the common shares as their preferred shares, for now, has a relatively high correlation to the appreciation of common shares, but will be giving out a significantly higher income stream. The only disadvantage is that the preferred shares are horribly illiquid and getting a fill at a decent price and/or size is not easy when nobody is trading.

First Uranium concludes recapitalization

First Uranium has concluded their recapitalization proposal by issuing $150 million worth of notes due to mature on March 31, 2013.

This is a very bitter pill for the equity holders to swallow – they will be heavily diluted by virtue of the conversion privilege attached with the notes, at $1.30/share. Assuming conversion occurs, this will result in 115.4 million shares outstanding more than their existing 166.8 million. In addition, to settle the contractual arrangements with another partner, they will be issuing 14 million shares extra.

All of this means that First Uranium’s existing stockholders, assuming full conversion, will have their holdings reduced to about 56% of the company. However, a significant shareholder (Simmer and Jack with 37% of the prior equity ownership) will also have $40 million of the issue of the notes, which if fully converted, will leave them with approximately a 31% stake.

Probably the only reason why they got into this offering to begin with was to salvage their ownership in the company, which was clearly going to slip away in an upcoming and very messy bankruptcy proceeding.

Gold Wheaton, a company that has purchased a fractional interest in the gold mined from First Uranium, also will be investing $20M and receiving 14 million shares as a result of a settlement on a contract that First Uranium failed to live up to. Assuming full conversion, this will give them about 10% of the company.

The Notes are guaranteed by the subsidiaries of the Company, secured by second ranking security over all assets currently encumbered by Gold Wheaton and first security over all other current and future assets of the Company, not be redeemable until maturity.

Assuming First Uranium will remain above $1.30/share, their recapitalization should be half done.

The other medium term issue for First Uranium, other than the establishment of its mining operations (and subsequent cash flow that would be produced by such operations) is that they have a $150 million issue of unsecured debentures that are due to mature on June 30, 2012, which I so happen to be holding.

First Uranium has a few options.

One is that they should be prioritizing their operations to be cash flow positive, which will make it easier to float another equity or debt offering that the market will be receptive to, enabling them to pay the subordinated debentures.

Another option, concurrent to the above, is that they have the option of paying off the debentures in shares of common stock at 95% of market price; at current market prices of $1.45/share, it would involve issuing another 109 million shares, for a grand total of another 27% dilution of common shareholders. This option will be progressively more attractive as the common share price goes higher. Such an action would be done in 2012.

Another solution is to renegotiate directly with the debtholders and sweeten the terms of debt (i.e. increase the coupon, lower the conversion price) in exchange for an extension of maturity date. This would require ratification of 2/3rds of the debtholders.

Ultimately if the company doesn’t pay up, the unsecured debtholders can force the company into bankruptcy. While their rank in the company, by virtue of subordination to this new issue of debt, will lead to low recovery, it is unlikely the owners of the company would want to proceed with this action and thus it is more likely than not that between now and the 2.2 years to maturity that there will be a way found to make the June 2012 debtholders whole. Simmers and Jack would not want the subordinated debtholders to pursue the “nuclear bankruptcy” option and thus it is more likely than not there will be a solution.

I do not believe First Uranium equity is a good risk at present prices, while I think the June 2012 debentures have probably priced in the right amount of risk and would present themselves as a speculative high risk opportunity.

Geopolitical risks of foreign operations

Kyrgyzstan is a country that probably was on nobody’s radar before a few days ago when the country went into a revolution.

However, some companies have operations in Kyrgyzstan – Centerra Gold has mining operations located there and correspondingly, their stock price took a drop with the heightened uncertainty:

Whenever having an investment interest in a Canadian-headquartered company with foreign operations, it always pays to keep an eye on the country where the operations are located. I am reasonably sure that if somebody was paying attention to Kyrgyzstan before their revolution hit the news, they could have protected their investment interests.

Athabasca Oil Sands IPO – First day of trading

The first day of trading of Athabasca Oil Sands resulted in a 6% drop in valuation from $18 to $16.90. I had written about my quick researched valuation of the IPO in a prior post, and also said that I wouldn’t be surprised if there was a post-IPO “bump”:

Once this company does go public it would not surprise me that they would get a valuation bump, and other similar companies that already are trading should receive bumps as a result. I have seen this already occur, probably in anticipation of the IPO.

If you had to invest into Athabasca Oil Sands and not anywhere else, I would find it extremely likely there will be a better opportunity to pick up shares post-IPO between now and 2014.

This kind of surprised me in light of the fact that this was much touted by the media before it started trading and it was appearing as if there would be droves of retail investors that would pile into the stock (before it went down). Instead, it just went down from the start of trading:

Probably what will be even more affected by this drop in valuation is the valuation of other related oil firms, which might get sold off now that the hype has been extinguished.

Inevitably, Athabasca Oil Sands will be running net operating losses for the next four years, so investors will have to be very patient before they will see any dividends coming from their common equity.