Anatomy of a trade decision

As I indicated previously, I am interested in trimming my long-term bond positions since I believe the market for less-than-stellar debt is becoming expensive for the risk taken.

Although I am adverse to income taxes, you should never let income taxation be the overriding factor in the decision to sell – valuation should be the primary consideration, along with your portfolio considerations, and then income taxes should be a secondary consideration.

An example today was trimming a trust preferred (which held a corporate bond) position in Limited Brands (NYSE: LTD) that I have held onto since late 2008. The security is due to mature in 23 years from now (March 1, 2033) and pays a 7% coupon semi-annually. The underlying company’s equity is trading relatively high, has a moderate amount of debt ($2.6 billion debt vs. $1.2 billion cash on hand), good income ($560M in the last 12 months) and an excellent brand name. So the underlying company, in the short and medium run, is likely to be solvent and be able to raise money and retain their cash generation abilities. It would not surprise me if they were able to be solvent in 23 years to pay off the underlying debt. My cost basis on the units are 35 cents on the dollar, which represents one of the best trades I have done in some time, but this will also represent a large capital gain when liquidating.

Back then, 35 cents on the dollar meant you got to collect a 20% current yield, and another 4.5% implied capital gain by waiting patiently. Now, the market has taken all of those coupon payments and gains and transformed them into a higher unit price – so instead of waiting 20+ years to realize that money, you can do it now. What I am trying to say here is – your cost basis is irrelevant except for factoring in the cost of capital gains taxation. The current market value that you can liquidate the securities with is the relevant factor – if I have $X that I can liquidate from this security, can I deploy it elsewhere more efficiently than the implied 7.7% it is paying me?

So why trim the position? 7.7% sounds pretty good over 23 years, doesn’t it?

There are a few reasons.

– The valuation appears high. At the current trading price (94 cents on the dollar) it is significantly higher than the underlying bond’s price that is available through TRACE. At 94 cents, your current yield is 7.4%, and your implied capital gain (which is the 6 cents of appreciation you earn upon maturity) is another 0.3%, so your total yield is 7.7%. While a 7.7% yield is about 4% higher than you can get with underlying treasury bonds, it still is not a sufficient threshold.

– I want to increase my cash balances. While I believe the next big macroeconomic move in the economy will be an inflationary cycle, it will completely depend on the timing of US politics. Right now the US economy is dominated by political considerations and this is why most businesses are choosing to hoard cash – since in times of political uncertainty you do not know the return on investment. A more business-friendly administration would result in a large inflationary spike. Right now we have the exact opposite of a business-friendly administration.

– I want to shorten the duration and term of my bond portfolio, for pretty much the point I made above.

– I do not need the yield, but apparently others do. They are willing to pay for liquidity, so I am willing to give it to them for a cost – they have to meet my asking price on the exchange.

– I am afraid that interest rates, while very low by historical standards, may increase. I am also not concerned to waiting a longer period of time for those rates to rise, and get to hold onto my capital in the meantime to perhaps deploy to a better area.

– Maybe the underlying business will face a downturn. It is in the consumer fashion industry, and while the Victoria’s Secret brand is unlikely to degrade anytime soon, maybe consumers will be a little more fickle in the future. I have no clue when it comes to retail fashion which trends will stay and which will not and can only evaluate these companies from a financial perspective. A great example is Coach (NYSE: COH), which to my neanderthal male mind, mainly makes handbags and accessories. But somehow this company produces insane amounts of cash. Will this trend continue? Who knows. But what I see financially there is a cash machine. I generally ask fashion conscious women for insight on these various names once in awhile to see what the intangible aspects of the brands are.

I am giving up a further potential upside of about 6% capital appreciation (since the trust preferreds contain a call provision they will not trade much above par value) in exchange for the safety and security of cold, hard cash. Right now I do not have any targets for my cash, so I will continue to be patient. Eventually the equity markets will contract and some opportunities will present themselves. It is unlikely it will ever be like late 2008 for awhile, but we will see.

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.

Trimming the long-term corporate debt position

Although not a huge fraction of my portfolio, I have trimmed some of my long-term corporate debt position in Limited Brands 2033 bonds, at a yield to maturity of 7.8%. I will be trimming more if the yield goes down to around 7.6%, and eliminate it entirely if the yield goes down to around 7.4%.

The risk-free rate (US government treasuries) for a 23-year maturity is about 4.5%, so the yield spread of 3.3% is not sufficient compensation in my eyes for the level of risk taken.

Limited Brands is a company that is in excellent shape after the 2008-2009 recession. They have about $2.7 billion in debt, compared to $1.8 billion cash on the balance sheet, and yearly free cash flow of about $900 million. Their “big name” store is Victoria’s Secret and they also operate Bath and Body Works. Although they have excellent prospects looking forward in terms of liquidity and solvency (and they have announced they will be giving out a $323M special dividend and a share buyback program, which is not good for bondholders although it speaks to the financial capability of the company to make such a move), I will lower my exposure to their debt as prices continue to rise and look elsewhere to get a better risk/reward ratio for my capital.

I think there is a good a chance as any of US bond yields rising considerably over the next few years, so this trade is also an adjustment with respect to my macroeconomic view of the world. It does lower the yield of my portfolio, but I am happy to keep the cash. It will stay as cash until such a time where I can determine where to deploy it in an efficient manner. Given what I see out of the markets, I don’t anticipate this will be a quick process.

Limited Brands Reports Q3 results

I will begin this post by saying I don’t understand the shopping mall experience. Perhaps because of my gender, I just don’t understand why people, usually women, like to “go shopping”.

However, I can understand what goes before my eyes, and that is people shop. I might not understand fashion retail, but I understand the economics of it – something about the marketing works. It gets people to pay more for a product that inherently has very low marginal cost to purchase. The embedded marketing costs, however, are huge.

Earlier this year, I invested in some corporate debt of Limited Brands (NYSE: LTD) – the 2033 series of debentures, which has a coupon of 6.95%. Investors back then assumed that retail was going to get thrown out the window along with the rest of the economy and especially for a discretionary retail shop like Limited Brands (their primary brand name is Victoria’s Secret), droves of people would be not shopping for lingerie. Or will they? According to their last quarterly report, they are on track to bringing in about $500-600M in free cash flow, depending on how the Christmas season works out.

For 35 cents on the dollar, I figured that the debt would be a good buy. It was tough to rationalize how being rewarded 20% interest a year (plus another 4% capital appreciation) under the assumption that Limited Brands would not blow up could lose money. And indeed, it has not lost capital – the same debt is trading for around 71 cents if you shop around carefully. This will still net you 10% a year in coupon payments, and about 1.5% a year capital appreciation compounded over the next 23.8 years.

If you look at their balance sheet, they have about $2.9 billion in debt, covered by $968M in cash, and positive earnings. Although I have no idea whether the retail chain over the next 23.8 years will survive, at least right now it is looking quite good.  The following is the debt maturity schedule from the Q2-2009 SEC filing, which shows they have staggered out their debt financing fairly well:

15. Long-term Debt

The following table provides the Company’s long-term debt balance as of May 2, 2009January 31, 2009 and May 3, 2008:

May 2,
January 31,
May 3,
(in millions)
Term Loan due August 2012. Variable Interest Rate of 5.18% as of May 2, 2009 $ 750 $ 750 $ 750
$700 million, 6.90% Fixed Interest Rate Notes due July 2017, Less Unamortized Discount 698 698 698
$500 million, 5.25% Fixed Interest Rate Notes due November 2014, Less Unamortized Discount 499 499 499
$350 million, 6.95% Fixed Interest Rate Debentures due March 2033, Less Unamortized Discount 350 350 350
$300 million, 7.60% Fixed Interest Rate Notes due July 2037, Less Unamortized Discount 299 299 299
$300 million, 6.125% Fixed Interest Rate Notes due December 2012, Less Unamortized Discount 299 299 299
Credit Facility due January 2010 15
5.30% Mortgage due August 2010 2 2 2
Total 2,897 2,897 2,912
Current Portion of Long-term Debt (7 )
Total Long-term Debt, Net of Current Portion $ 2,897 $ 2,897 $ 2,905

Another similar corporation that is debt-free is Abercrombie and Fitch (NYSE: ANF), which seems to defy everybody’s expectations during recessions by coming back from the financial netherworld to make insane amounts of money. I can see the appeal of Victoria’s Secret – sex sells – but Abercrombie? When walking into the two stores to do some ‘consumer research’, I just don’t understand what keeps these names afloat in the retail fashion world.

However, I can at least invest and make some cash off of it while the going is good. Will I know when it is time to liquidate? Who knows.