Weekend Readings

Enjoy the weekend morning coffee with a copy of Mr. Buffett’s wisdom:

- Berkshire’s Annual Shareholder Letter: A required reading. Will be out on Saturday the 27th.
- When CEOs have Warren Buffett in their Boardroom: By Alice Schroeder about the way Buffett works with CEOs of companies he has invested in.
- How a New Jobless Era Will Transform America: The impact on the high unemployment rate on the current and future generations.
- Sears Holdings’ Chairman’s Letter: The annual shareholder letter from Eddie Lampert, covering American policy, unemployment, and retail market.

Ternium: Steel Solid Results

Steel companies have been hit hard in 2008 and 2009. Most companies have put up negative cash flow numbers, with only a few that have successfully made it through the two years without burning cash. Our investment in Ternium was based on the analysis that the company is one of the best operating steel companies in South America and the world. The 2009 Q4 results again showed why we believe them to be one of the best. Some highlights from the report:

- Shipments increased by 7% compared to Q4 ’08. Compared to Q3 ’09, shipments were down 2%. A strong showing that demand for production has stablized
- EBITDA per tons increased 12%, compared to Q4 ’08. The company reported $177/ton EBITDA, extremely strong results compared to what the rest of the industry is showing.
- The company had EBITDA of $316 million. The company used the cash to pay off $121 million of debt in the quarter.
- In 2009 the company had cash flows of $953 million. Compared to the current EV of $7B, that is a little more than 7x of cash flow.

One of the metrics used in track steel companies’ performance is EBITDA per ton. The companies that are low-cost producers and have strong production volume usually show the top ratio. We can see a comparison of some of the major steel companies’ EBITDA/ton ratios at the Nerds of Steel earnings spreadsheet. Ternium has shown dominant and consistent performance on this ratio. It has ranked at the top with Posco, Buffett’s favorite steel company, and Gerdau. Ternium’s strong cash flow, low-cost producer, and located in one of the rapidly growing regions makes it an extremely compelling steel producer at current prices.

GGP: BAM and Westfield updates

The GGP world is moving at a pace faster than the internet world speed. Since our update over the weekend, the following has happened in 3 days:

- BAM and GGP have come up with a counter-offer to the Simon offer. The proposal values GGP at $15 and proposes splitting GGP into two: one holding the top class assets (GGP) and another holding the remaining (GGO – General Growth Opportunities. In return BAM would get 30% of GGP. I think this is a good offer but it really just creates a floor for GGP share value. There will be more bidding in the coming days.

- Simon has signed a Non Disclosure Agreement with GGP. Simon had initially protested against the terms of the NDA. After the BAM/GGP plan was made public, Simon quickly signed the NDA. We have said it would be foolish to rule out Simon in this bidding war. Simon signing the NDA is a clear sign that this is far from over. I accept another offer from Simon in the coming days.

- Westfield has signed a NDA with GGP and is considering a bid. Another bidder will make it even more interesting for current share holders. This is a major positive for shareholders.

GGP owns some of the most prized retail shopping mall assets. An opportunity to purchase these assets at valuations based on the Simon and BAM proposals are a once in a lifetime chance. It is extremely hard to see Simon or BAM not increasing their offer as the bidding war progresses. I think the recent offer from BAM is not the final offer. I except an increased offer in the coming days.

GGP: Updates

I had initially thought about providing updates on GGP on a daily basis. Although with the way things are moving, what happens in the morning seems like old news by the end of the day. Here are the recent updates:

- Bruce Berkowitz, of Fairholme Capital, recently announced his interest in helping GGP come out of the Chp 11 as an independent company. Fairholme own over $500M of GGP debt and has mentioned that he is interested in helping GGP “emerge from bankruptcy as healthy as possible without a takeover and with the ultimate conversion of Fairholme’s stake into equity.”  This will create a big dent in Simon’s takeover plans.

- Brookfield Asset Management has been rumored for a while to be interested in a JV with GGP. BAM recently amended its shelf offering, now offering $2B instead of $1B. Recently GGP mentioned they were looking to raise $1-2B to pay off the unsecured creditors. This is definitely an option for raising capital.

- Simon started the initial bidding war with its $10B offer. There has been lots of talk about David Simon’s public outcry over GGP rejecting Simon’s offer. It would be foolish to rule out David Simon in any takeover bid. Recently the rumor has it that Blackrock is joining Simon in Simon’s takeover bid. Even with the debt rating warning by S&P, Simon is not out of the running. It would be a mistake to rule them out.

The great news for equity holders is the bidding from these firms will only increase the equity value. GGP’s management has the right incentives to increase equity value and to get it done quickly. With the recent rumors and activities, equity holders will not have to wait too long to for this process to complete.

If last week was a sign, the coming week will be extremely interesting.

New Purchase: ATP Oil and Gas

We bought a position in ATP Oil and Gas yesterday. More on our thinking in the coming days.

Simon bids for GGP: Bidding war begins

The bidding war for GGP officially got started today. Simon announced a $10B offer for all of GGP. The offer looks like Simon trying to low-ball GGP. To us, this offer has no chance of being accepted. We know there will be many more offers coming, with the price increasing substantially.

Let’s look at the Simon’s offer. The 10B offer is $7b for unsecured creditors and the remaining $3B is for equity.

Simon’s offer would provide a 100% cash recovery of par value plus accrued interest and dividends to all General Growth unsecured creditors, the holders of its trust preferred securities, the lenders under its credit facility, the holders of its Exchangeable Senior Notes and the holders of Rouse bonds, immediately upon the effectiveness of a definitive transaction agreement. This consideration to creditors totals approximately $7 billion.

General Growth shareholders would receive more than $9.00 per General Growth share, consisting of $6.00 per share in cash and a distribution of General Growth’s ownership interest in the Master Planned Community assets valued by General Growth at more than $3.00 per share.

Now, with unsecured creditors they will agree to any offer that provides them with 100% of their par value plus accrued interest and dividends. This is the most, in cash, that unsecured creditors can get anyways (unsecured could go for an offer where they convert to equity buy Simon’s offer didn’t mention this). So Simon saying that 100% of the unsecured agreed to the offer doesn’t really mean much.

The interesting thing about this offer is that now the market knows that unsecured will get 100% and equity is likely worth something. Interestingly, after the offer was made public the GGP equity was trading around $12/share for a market cap of over $3.75B. This means, the market was expecting another higher offer.

Later in the day, we got news that Bill Ackman believed that the value of GGP equity “is worth as much as 3 to 4 times what Simon is offering — on the order of $30 to $40 per share”. We agree with Ackman that GGP is worth much more than what Simon is offering. Although the range that Ackman mentions in at the high-end of the range.

We still have plenty of other interested players, including BAM, that will likely make some public statements in the coming days. The games have begin and we expect a few more rounds before all is said and done.

State struggles

Watching the stock market in the last 6 months might make you believe that the good times are here. Although we still have a long way to go. For one, many of the states are struggling with their budgets and will struggle in balancing their ‘check books’. We expect taxes to increase in many states.

Nevada’s budget is so far out of balance that by one account the state could lay off every worker paid from the general fund and still be $300 million in the red. The economic downturn has hit so hard that prisons may be closed, entire colleges shuttered and thousands left without jobs.

Quarterly Update: Setting up for a strong year

The Q4 of 2009 was a strong finish for a year that will go down as one of the wild one in history. From an investment perspective, we hit the bottom in early 2009. In the end of 2009, the market was brimming with optimism and was in high spirits. As someone once said, things are never as bad as they seem and never as good as they look. The fear in early 2009 was shown to be incorrect by late 2009. The optimism in late 2009 was shown to be wrong by early 2010.

For us, our investments finished strong. Our biggest holdings, CPD and GGP, moved closer to fixing the major issues hanging over the company. Whereas some of our smaller holdings, Penn Traffic and RHI Entertainment, ended the year with the least likely outcome. In all, we were extremely pleased with how 2009 ended and we look forward to an exceptionally strong 2010.

Here are the updates on our holdings:

Caraco Pharma: CPD recently announced its quarterly earnings. The quarterly numbers were a non-event for us. We were interested in the update related to the FDA compliance. CPD reported that it has started hiring back some of its former employees in expectations of receiving FDA compliance. CPD also reported that it has moved manufacturing of certain drugs to other facilities, highly likely Sun Pharma’s NJ plant. These two events are major news as it shows that the company will likely get to break even or cash flow positive shortly. Also, the rehiring of employees is a huge indication that management expects to receive FDA compliance shortly. We expect the company to be back in compliance before end of 2010. In the meanwhile, the company will likely get to cash flow positive.

General Growth Properties: The company has been an exception story in 2009. Management has done an amazing job in 2009 to get through the bankruptcy and protect/increase shareholder value. In last 2 month of 2009, the management and legal team did an amazing job in getting most of the properties out of Chp 11. We expect in 2010, the company will either get bought out or emerge from Chp 11, either as a standalone or in a joint venture. In the next 2-3 months, the route the company will likely take will become much more evident.

WellCare: Our initial investment thesis has worked out exactly as we expected. The company cleared all the major legal hurdles related to the Florida Medicaid investigation. The fines to be paid relating to these legal issues are minimal. Even with the legal issues behind them, the shares have not rebounded. As the strong earnings start showing, we expect the shares to increase substantially from the current levels.

Ternium: This company had a roller coaster year. The shares dipped to ridiculous valuation as fear ran wild that steel companies could not sell their inventory. It was true that steel companies were struggling, Ternium stood out as one of the best run steel companies in the world. Management did an exceptional job in getting $4B for its Venezuela operations. The company is on track to pay off a substantial portion of its debt and improve its Mexico operations. We believe 2010 will be a decent year for the company but the future looks exception for one of the best run steel company.

RHI Entertainment: The company has had a rough 2009. From a cash flow perspective, the company has failed on delivering the made-for-TV movies. The company has concerns about valuation of its library and whether the company will be able to stay out of default. We still believe in the management and the business model. We believe the company is going through extremely difficult economic times. If the company can delivery on the movies and create recurring revenue from the library, the company will survive. The 2009 Q4 results will show whether the company delivered the movies and the valuation of the library.

Harvest Natural Resources: We believe this is an extremely undervalued energy play. The management is shareholder friendly and has made exceptional moves to increase value. Most recently the company announced they will issue 32M of convertible debt. Although we don’t like the dilution, we believe the dilution will be very minimal. Also, the management is looking at a financing deal where  it will monetize the next 5 years worth of Petrodelta dividends for $250M. We believe this will provide enough financing to explore the worldwide HNR options, a hit on anyone of these worldwide options will dramatically alter the company’s valuation. We are excited about the US Antelope potential.

PhotoChannel: We recently commented on this one in another blog entry.

Premier Exhibitions: Management has definitely turned this company around. It is no longer bleeding cash. Management has started working on creating growth and focusing on initiatives that will increase cash flow. The company is also waiting to hear the court ruling on its Titanic assets. We believe at current prices the company is extremely undervalued.

Palladon Ventures: This is a pure speculative play for us. On asset valuation basis, the company is selling at ridiculous valuation. The company’s assets in Utah are worth substantially (well over 10x) more than the current market value of the company. Although the company has many challenges ahead in getting production and shipment of its Utah assets. If the company can delivery on the shipment of the iron ore, we can easily hit a home-run (10x) return. We believe the next 3-9 months are crucial for the company to work through its debt issues, working out the agreement with China, finding a new customer, and finding a solution for production/shipment.

KVH Industries: The company’s strong recurring revenue stream and growing business bode extremely well for shareholders at current share prices. The company has a clean balance sheet, a recurring business model that will create huge cash flow, and a growing business segment. We believe the shares at current prices could be a 4-5x return in 2-3 yrs.

CombiMatrix: This is a wonderful heads-i-win and tails-i-don’t-lose situation. The company is selling for a slight premium to cash. The company has many valuation options that could provide a huge return at current prices. Management has been working on selling the company, either in parts or in whole. At current prices it is an easy double. If one of the many ‘options’ work out, it could be worth substantially more. On the worst case scenario, the cash protects the downside.

We are currently invested at:
Equities: 95%
Cash: 5%

Although, our cash level is much lower than we would like, our current holdings have a substantial number of event driven holdings that should materialize in the next 6 months. Roughly 40% of current holdings are in cash and ‘event-driven holdings’.

Currently we are still finding opportunities to buy solid businesses, with strong management, at cheap valuations. As our current event-driven holdings play out, we believe we will still have opportunities to capitalize.

PhotoChannel: Strong cash generation, but

Photochannel today announced their 2010 Q1 results. The numbers were very good.

- Generated $2.7 of EBITDA in the quarter
- Top line grew by 8% (16% if you account for currency changes)
- 5.6 million transactions were recorded, a record for the company
- Expenses look like they have stabilized, even decreased in some areas
- Ended quarter with over 6M of cash
- Board has approved share repurchases

The quarter was very good in terms of cash generation. Also, the cash balance has increased substantially and the share repurchase is a strong signal that shares are undervalued. With the Q1 EBIDTA of $2.7M, we would expect the company to make around $7 EBIDTA cash for the 2010 fiscal year. The board’s repurchasing of shares is a good signal that management is utilizing the cash in a very prudent manner. If they were to spend the entire $2.7M cash generated in the Q1 towards share repurchase, management could buy back around 5% of the company.

Now here comes our ‘but.’ Our initial investment thesis was based on our expectation that the online retailer-based photo processing business was a huge market. We predicted a substantial move by customers towards retailer’s online services, leading to strong growth potential for Photochannel. Photochannel had only 8% increase in revenue in the quarter. We don’t buy management’s argument regarding currency, it is part of the nature of their business so we don’t think it is right to not consider it. So the increase in top-line makes us question our initial thesis about the target market.

We get a sense that our initial take on the market was likely wrong. The online retailer based market might be much smaller than we expected. The market is likely a niche market with a tough sell to get customers to switch away from other online photo finishing services. A smaller market would mean the top line growth for the company will be much lower than we expected, impacting our valuations.

On valuation, we see the company making $7-8M of EBITDA this year. The transaction revenue for the last 12 months is $18 million. Let’s take into account 15% growth for the next 3 yrs, you get to $27M for transaction revenue. Lets say 70% of the transaction revenue growth hits the bottom line, so an additional $6M EBITDA. So we are looking at around $13-14M in EBITDA in 3 yrs. Lets slap a 10x multiple and we see a $130M market cap. Take into account the accumulated cash and we can see the company worth around $150-160M.

Now this is still a 3x from current prices. Although we realize that our investment thesis has changed substantially. One of the biggest inputs in our initial analysis has changed. Also, we are not confident that the company can grow top-line at the 15% clip. If the market is infact a niche market then 15% growth might be tough to get, we are assuming no major retailer is added.

Overall, we quarterly results are great and company is moving in the right direction. Although our initial investment thesis has changed substantially. When the reason for investing changes, then it is time for us to leave. We will likely head towards the exit door on this investment.

Tilson’s presentation on GGP

Whitney Tilson recently presented a potential valuation for GGP. He made an argument for GGP getting a comparable valuation to Simon Properties. Based on GGP’s asset quality and NOI, we agree that GGP should command at Cap Rate around 7%, which should mean a share price of $25. We think in the next 6-9 months the shares will reflect a much more fair valuation of the share prices.

T2 Partners Presentation