Category: Equity

Another week of summer trading

I don’t think price movements should be taken too seriously this week or for the rest of the month. The price changes do create volatility that can be taken advantage of, however.

That said, I am beginning to have a few “hits” on my equity radar that are deserving of more research, so hopefully I will have enough time to look at them since I have been taking things relatively easy myself.

I continue to trim my long-term bond position in Limited Brands; I had the selling side of the trade at the 52-week high, but I didn’t have my entire position filled and now the position is trading about 1% less than that amount which is somewhat frustrating – I just wanted to clear out the whole thing at 96 cents. TRACE has the bonds at 92 cents on the dollar, while the exchange-traded version had them at 96 cents on the dollar, so I am unloading and taking my money. I remember the days that TRACE had them at least 5-10 cents higher in the bond market vs. the exchanges, so the market is relatively inefficient on these illiquid issues – a high volume day is considered to be $50,000 traded.

I also note my other long-term bond positions are creeping higher. If they get to the 8% yield stage I’ll consider a liquidation of them, and leak the position and fully dump them at around 7.5%. I also have to time whether I can unload them in 2011 for roughly the same value for tax reasons. TRACE has those exchange-traded issues and the bond values at roughly the same value at present so I am not losing a premium valuation by waiting.

I am also trimming my only equity position, which I had a very minor stake in. It was an obscure play that was slightly under-valued and had a market catalyst that never emerged. It has appreciated somewhat, so I am selling it. With my track record it will probably go up 2000% over the next 3 years after I dispose of it all.

All of this should make for a third quarter update that should hopefully show some more cash in the portfolio – assuming I don’t buy anything, it will get over 10%. Although cash yields a paltry 2% at present, it gives me the opportunity to strike at other opportunities when they arise and come to my attention. It is very difficult to do this when “fully invested” since going into margin to invest involves its own separate set of risks.

I am playing things ultra-conservatively, which doesn’t make for good writing, but at least I will be solvent.

I am also still looking for income-oriented securities, but I am finding this entire sector to be swamped with over-valued issues. It is painfully clear to me that the large amount of money sloshing around there is looking for yield.

Superior Plus – why do they look cheap?

A company that has always stuck out like a sore thumb on my stock screens has been Superior Plus (TSE: SPB). It does this by virtue of its relatively high dividend yield ($1.62/share, $13.50/share = 12%). It converted from an income trust to a corporation and did not reduce its payout rate simply because it was able to engage in some financial engineering to give it a very, very significant tax shield ($800 million in pre-tax income = approximately $200M in tax) against future income taxes.

Putting a complicated tax story into simple terms, income trusts were able to engage in transactions with loss-bearing corporations to give themselves a shield against future income taxes, something corporations were unable to do because there are extensive CRA rules that explicitly define how you can and cannot do it. Superior Plus essentially bought out Ballard Power Systems, while the previous Ballard Power Systems formed a new corporation, transferred its assets to that corporation, and life went on as normal, except that they monetized $800 million in tax losses for approximately $50 million. The Canadian government was able to close this for future income trusts in the 2010 budget.

One reason why Superior Plus is able to maintain their high dividend rate is that they can avoid paying Canadian income taxes for the foreseeable future, assuming the CRA and/or tax courts will rule that such transactions were valid (i.e. they had some form of business substance opposed for just doing a transaction for tax reasons, which there are court precedents established). So their CFO gets high grades for pulling off that transaction, assuming it works!

The company itself is diversified into four segments – energy (propane, fixed-price energy contracts), specialty chemicals and construction products dealing with insulation, walls and ceilings. The businesses weighting, by gross profit as stated in the March 2010 quarterly financials, is roughly 60/20/20. The company traditionally has been profitable, with revenues around $2.2-$2.5 billion, and income around the $70M range in the last two full fiscal years. Cash generation has been significant, with about $200M generated in the last two years, and averaging about $100M in capital expenditures. Dividend payments are about $150M/year at the existing rate.

This is the area where an investor should stop and think – if your business is sending $250M out the door, but is only generating $200M in cash, how does that get bridged? Long term debt issuance. Indeed, debt from the end of 2007 to 2009 has gone up approximately $370M to pay for this and some acquisitions. About half their total debt load is in bank loans, and half of it is in debentures. Indeed, the market doesn’t seem to mind this – their debentures are all trading close to par value. Their balance sheet otherwise is unremarkable, with equity minus goodwill/intangibles at around negative $150M.

Unless if Superior Plus is able to either generate more cash, or reduce capital expenditures, their dividends currently are unsustainable and probably need to be chopped by about 25% or so for the health of the overall company. They would be smart to think about de-leveraging a little bit – they have about $240M of debentures due in December 2012 and one would consider that the after-tax cost of capital is higher when you have such a huge tax shield to work with.

This is likely the reason why Superior Plus is trading relatively “cheaply” – investors clearly have priced in the fact that their dividend distribution rate is too high given their cash flow and capital expenditure requirements. The company otherwise appears to be in good shape, but I won’t be investing in their equity at existing prices.

Fine-tuning my BP model

About two weeks ago I stated to exit “between $45 to $50/share”, but there have been a couple significant events between now and then and the price response I’ve judged – one is the departure of the CEO (which was to be expected for his very lackluster performance in this whole matter – he did not care, and won’t be caring after a massive severance package payout) and the accrual for the project (approximately $32 billion dollars) which was roughly what I had expected (my estimate was $40 billion). Note that this amount is not a cash amount, but rather it is an accrual expected to be paid out in the future. If the oil spill is less damaging than expected, they will reverse this in the future and take a gain.

Because of income tax provisioning, the after-tax cost to shareholders will be less than this.

Also you can be sure that other, less performing projects will be thrown under the bus – this is always something to be aware of when companies make massive charge-outs. Tech companies doing mergers back in the internet boom were infamous for doing this, and was a reason why such financial statements looked better – if you keep on taking “one time charges”, your continuing operations will look great!

Since predicting the price of BP has been much more of a political game than financial, I believe being able to compile both sectors into a blended decision is one of my competitive strengths in the marketplace. Upon retrospection, I believe my initial price estimate for BP was high, and will now lower my exit parameters to “$42 to $47” per share. I would hazard a guess that it will get into this range by year’s end as the public consciousness fades onto other issues – such as the impending war in the Middle East (due before Obama’s exit in 2012) and how the US Congress will end up making themselves look like even bigger fools in a mis-guided attempt to save their collective skins in the November mid-term elections. The collateral damage that both events will leave should erase the BP oil spill from our short-term memories.

Since the price target is not materially above BP’s existing share price, the risk/reward ratio is not tremendously good. Obviously back a couple months ago when oil was still gushing in the Gulf, the risk was much higher. The “emotional” feel of this story is a fairly good lesson on the rule of the stock market – you don’t see low prices without risk. If you see what you think is a low price, but can’t see what the risk is, then chances are there is a hidden risk out there you are not aware of. Find out what it is before buying.

Finally, on the issue of collateral damage, Anadarko (NYSE: APC) and Transocean (NYSE: RIG) which had a 25% residual interest in the project and the drilling contractor, respectively, have both gotten killed in this crisis. They both look like better risk/reward ratios than BP is at the moment.

BP – When to exit?

Earlier, specifically on June 16, I stated the following about BP:

For people that insist on getting into BP, the next couple weeks should be a good time. The exact timing in terms of price is an unknown variable, but I would estimate layering in 25-30 dollars a share (e.g. if it goes down to 28, you will get a 40% allocation).

Indeed, the common shares fell to a low of 26.75, which means that using the “25-30 dollars a share” algorithm would have resulted in a 62.5% position (e.g. if your typical position is 5% of your portfolio then you would have ended up with 62.5% of 5%, which would be 3.125%). The average price would have been $28.375/share, not factoring in commissions.

Now that BP has risen and the big headline (“they’ve solved the oil leak”) has come out in the news, it brings up questions of what the ideal price to liquidate will be.

I see a two-phased trading approach should work well. The first phase should involve an immediate bump up due to the “news” coming out. This has mostly occurred, as you can see by this one-day chart:

After attracting the initial wave of profit-takers, I anticipate a second wave of demand coming for BP shares which should bring the stock to the $45-50 range. This is the target I would set for my sell order. The simple justification is that I estimate this whole debacle should cost BP about $40 billion dollars, or about $13/share. Before this all began, BP was valued at around $60/share, so simple math would assume an approximate $45-50 valuation, hence the sell point at this price. Assuming the exit is achieved, you would be looking at around a 67% gain on the transaction, which I would estimate between now and the end of the year.

This is a very elementary valuation exercise; naturally to properly model the situation you have to take into assumption the strategic effects of the oil spill (i.e. reduced offshore drilling in the Gulf of Mexico) but also have to strongly factor political considerations.

I have not and will likely not trade common equity in BP, but I have sold puts on Transocean and they have moved out of the money at present from my initial transactions. They will likely expire in August.

This was probably one of the better trading opportunities I have seen in 2010.

Nokia valuation

I have read some posts by people out there that believe that Nokia is a value play and is worth purchasing. It is trading at a price that is lower than it has been in a decade ($8.36/share presently; as late as 2007 it was $40/share). I’ve briefly looked at Nokia and, financially speaking, while they have a decent balance sheet and some positive net income, their profitability is sliding down and this represents why the market has discounted the stock.

The first item I would like to address is the dividend – it is very likely it will be slashed. An investor putting money into Nokia for the dividend is going to be very disappointed, likely within a year. Nokia will need to go into a cost cutting and capital conversation mode soon and the easiest thing to go before making the very difficult decisions is the dividend.

However, the proper valuation analysis for Nokia is not a financial one; rather, it is determining who is going to be the winner in the mobile handset space. A decade ago, Nokia was clearly the champion in this industry – for the most part they edged out Motorola and Ericksson (now Sony Ericksson).

Between then and now, we have seen a huge quantum leap in mobile technology. Voice functions are trivial – it is all about mobile data, web and video. Apple has invaded the space with their hardware/software offering (iPhone), and Google has invaded the space with their software (Android). These two factors alone have likely put Nokia behind with inferior product offerings.

While I am not the techie I used to be when I was younger (I no longer follow the computer hardware scene and my cell phone is a 2004 Nokia model that I use exclusively for voice and will feel bad if I lose it), I still peripherally follow the industry. It has matured so quickly compared to when I was a teenager that it has gotten relatively boring. That said, there are plenty of people out there that follow it feverishly, and the following comment by somebody following Nokia’s operating system (Symbian) pretty much sums up the picture:

To Nokia, you guys are losing. Hard. Wake the hell up. Doing the same thing repeatedly while expecting different results is the definition of insanity. I’ve been a huge Nokia fan since my 2nd cellphone, and I just can’t do it any longer. You guys aren’t competing like you once were, and everyone but you seems to see that. You used to build the world’s best smartphones, the world’s best cameras, the world’s best GPS units – you’ve lost pretty much all of that, and with nothing to show for it. You unveiled your Ovi vision over 2 years ago – I was there. Today, it’s still a complete mess. I have to log in every single time I visit the site – regardless of how many times I check the ‘remember me’ box. I spent 6 months (and about 3 hours at Nokia World 2009) trying to find someone to help me with Ovi Contacts on the web – no one knew who to point me to. You spent millions of dollars purchasing your Ovi pieces – Ovi Files, Ovi Share, and a host of other little companies – are you proud of what you ‘built’ with them? Most of your own employees (that I’ve talked to) don’t even use them, so why should I?

This really reminds me somewhat of what happened to IBM’s OS/2 when they were competing against Microsoft in the desktop operating system marketplace. Another example is what happened to Cyrix when they were competing against AMD and Intel for the processor market. Both had inadequate offerings and were only running on steam before they finally folded – Cyrix was bought off by IBM, and OS/2 was canned. I am sure there is a better analogy that would apply to this particular situation, but the point is the same – Nokia’s mobile platform, in absence of something completely hidden and not marketed yet, is toast.

Without control over the platform, there is no opportunity for them to gain a market premium, and they will become a commodity producer of mobile hardware – a very low profit industry. Nokia’s best option is likely to sell out as quickly as possible to the highest bidder since with every passing week they will be commanding less of a premium on the market.

If Nokia’s board of directors are rational, they should be looking for an exit, but finding somebody willing to fork out $31 billion to buy out the company (this assumes no takeover premium) would be difficult. As such, I wouldn’t touch Nokia equity – investors are likely to face continued losses. You might even be able to make a good case for a short sale, but my knowledge in this area of the business world is not comprehensive enough to make such a decision.