Thursday, October 27, 2016 0 comments

Purchase (Special Situation): Ingram Micro

I'm continuing to expand into more risk arbitrage positions. This time, Ingram Micro (NYSE: IM). Unfortunately, all are Chinese deals and there is somewhat increased risk of some event derailing all of them at once so hopefully I find something completely unrelated soon.

Ingram Micro (IM) is a reseller/distributor of information technology products, with a few additional services. It is being bought out by Tianjin Tianhai, a Shangahi Exchange publicly-traded Chinese subsidiary (shipping/logistics) of the large HNA conglomerate (aviation/tourism/logistics). It makes sense from a strategic point of view since the logistics business can be utilized by the Ingram Micro IT distributor business.

Ingram Micro is not that good of a business so it isn't one that I would be pleased to hold if the deal fails (in contrast, recall that Syngenta is one that is a good one). However, the valuation for Ingram Micro is not that high so the stock likely won't fall too far if deal fails.

With my assumptions, the expected return is around 6.5% (you are looking at a raw return of around 8% if deal closes). If the deal closes within a few months, the return is pretty good. But if it drags on, then the return is just ok.

Anyway, here is my analysis of this deal...

Takeover price: $38.90

Deal closing: 2nd half 2016

Purchase price: $35.87

Prob (success) = 95%
Return  (success) = 8%
Prob (failure) = 5%
Return  (failure) = -30% (assume it drops to $25, about 10% below pre-takeover price)

Expected Return = 6.5%

Buffett's Four Key Questions

(1) How likely is it that the promised event will indeed occur?

I think the chance is very high and think it is about 95% of success. Shareholders have approved deal. Financing does not appear to be a risk with the Chinese firm already working to line up funding (the parent company is also very large and can likely source funds if necessary). Risk lies with CFIUS, which is the American government agency that evaluates foreign takeover where national security is a concern. This entity is politically motivated and it is impossible to be certain of any outcome (their decisions are generally not consistent). However, based on public analyst comments and my understanding of Ingram Micro's business, they don't really deal with any sensitive items and don't really have much intellectual property or proprietary products/services (Ingram Micro is essentially a reseller/distributor of IT products). The small amount of business involving the US government, and it does sell some security products, have several competitors that will offer the same products/services.

Initially, the deal was not going to be submitted to CFIUS (later, after some CFIUS consultations, they decided to submit an application) and this leads me to believe that the bidder and Ingram Micro management initially felt there was little national security or sensitive products/services involved. Their assessment is probably correct and gives an indication of how confident they were with regulatory issues.

(2) How long will your money be tied up?

Deal is expected to close by 2nd half of 2016. As soon as CFIUS ruling comes out, I expect the deal to close within a month. Initially the deal was not going to be submitted to CFIUS but on the July 21 press release they stated that they were going to submit. CFIUS has a 30 day review, optionally followed by a 45-day detailed investigation. It may have been submitted to CFIUS a bit after the July 21 press release so we should be getting a ruling in October. But this can probably drag on if there are further questions and actions the merger entities have to take. A reasonable worst case might be 1Q 2017.

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

Zero chance of something better. Ingram Micro doesn't have a great business that would interest many.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

I am guessing that the stock will drop to around $25, which is about 10% below what it was trading at before takeover. Stock has been in a range between $23 and $30 for the last 3 years. The business isn't that great but the valuation isn't that high and makes up for it. Presently, it has a P/E around 21 (forward P/E according to Morningstar of 12), P/B of 1.3 and long-term P/FCF is probably in the 20s and ROE is around 7%. If it drops to pre-takeover price, it'll be trading around book value.

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Monday, October 24, 2016 0 comments

Fortune 500: 1996 vs 2016

Was going to do more analysis on this but for now, I'll just write a short post.

I took a look at the top 20 Fortune 500 companies and compared them to what they were 20 years ago, in 1996. For those not familiar with Fortune 500, it is solely based on revenue. It ignores market cap, profits, and so forth. Because it uses sales (or revenue), the picture it presents is often quite different from, say, the S&P 500.

1996 2016 % change
Rank Company Revenue Rank Company Revenue
1 General Motors  $      168,829 1 Walmart  $        482,130 415%
2 Ford Motor  $      137,137 2 Exxon Mobil  $        246,204 124%
3 Exxon Mobil  $      110,009 3 Apple  $        233,715
4 Wal-Mart Stores  $        93,627 4 Berkshire Hathaway  $        210,821
5 AT&T  $        79,609 5 McKesson  $        181,241
6 Intl. Business Machines  $        71,940 6 UnitedHealth Group  $        157,107
7 General Electric  $        70,028 7 CVS Health  $        153,290
8 Mobil  $        66,724 8 General Motors  $        152,356 -10%
9 Chrysler  $        53,195 9 Ford Motor  $        149,558
10 Altria Group  $        53,139 10 AT&T  $        146,801 84%
11 Prudential Ins. Co. of America  $        41,330 11 General Electric  $        140,389 100%
12 State Farm Insurance Cos  $        40,810 12 AmerisourceBergen  $        135,962
13 DuPont  $        37,607 13 Verizon  $        131,620
14 Texaco  $        36,787 14 Chevron  $        131,118 309%
15 Sears Roebuck  $        35,181 15 Costco  $        116,199
16 Kmart Holding  $        34,654 16 Fannie Mae  $        110,359
17 Procter & Gamble  $        33,434 17 Kroger  $        109,830
18 ChevronTexaco  $        32,094 18  $        107,006
19 Citicorp  $        31,690 19 Walgreens Boots Alliance  $        103,444
20 Hewlett-Packard  $        31,519 20 HP  $        103,355 228%
US GDP (1996)  $8,100,201 US GDP (2Q 2016)  $18,561,000 129%

As most value investors would know, sales is more stable (hence why some believe P/S (price to sales) is more predictive of investment performance than P/E or EV/EBITDA or whatever). The Fortune list reflects the stability.

At first glance, it might seem that the companies have changed quite a bit but a lot of that is misleading. Quite a lot of the changes are due to mergers and acquisitions and restructurings and it isn't evident in the list (some companies like Berkshire Hathaway weren't listed for various reasons). Very few companies' sales actually declined; rather, even when they appear to decline, it is because the company may have sold off a subsidiary, spun it off, and so forth. Looking at something like General Motors (GM) is illustrative of this.

Between 1996 and 2016, GM went bankrupt and shareholders lost everything. GM also shut down several prominent subsidiaries (Pontiac, Saturn, etc) and shed non-core assets and liabilities including golf clubs, "toxic" assets, pension liabilities and so forth. Yet, even after all this negative activity, GM's sales have only declined about 10% to $152 billion from $168 billion in 1996. (For reference, high-flying electric vehicle maker Tesla's sales is only about $4 billion right now--it'll probably take Tesla 30 to 40 years to reach GM's sales. Having said this, Tesla can likely generate higher profits and can be worth more even with less sales.) GM is a good example of a company with dominant, albeit low-margin, products but incompetent management and poor shareholder governance (at least for the last several decades).

As with many top ranking lists, if you are a contrarian like me, you have to be careful with companies that may be hitting the peak or is too popular. For instance, HP has increased its sales significantly (compared to 1996) but it has been struggling lately and it's not clear if it is entering a period of decline.

Since the Fortune list is based on sales, one should check against GDP, which kind of represents the "sales" for the whole economy, to get a feel for how these companies are doing. Admittedly, most of these companies are global and generate foreign sales but I think the US GDP is still a good proxy.

US GDP went up by around 129% in 20 years, which is less than the very-long-term average I would expect. In the long run, US economy has grown around 3% real and 3% nominal for a total nominal GDP growth rate of 6%. If you ignore foreign markets, US companies should growth their sales by around 6% per year (at a minimum they should grow by 3% to cover inflation--right now inflation is lower at around 2% but that's unusual in my opinion.)

Most of these companies appear to have grown faster than US GDP growth, which is good for their shareholders (this outperformance likely came from foreign sales).

Anyway, hope to revisit this in the future with more thoughts.

Sunday, October 23, 2016 0 comments

Sunday Spectacle CXCVII

Evolution of the Airline Logo
The logos of some of the major airlines over the decades...

(source:The Evolution of the Airline Logo by Just The Flight.

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Saturday, October 22, 2016 0 comments

Purchase (Special Situation): Syngenta

After pondering this for a couple of months, I decided to take a risk arbitrage position in the Syngenta (NYSE: SYT) takeover by ChemChina, a large Chinese company.

I was vaguely familiar with Syngenta because I did some very preliminary, limited, research on it about 5 years ago when I was looking at non-commodity agricultural businesses such as Bunge. This is one of those deals where the expected return (based on my assumptions) is quite low (5%), which is below my usual target (I like to aim for 10%+, preferably 12%+). The raw return is 9% so if everything goes as planned on time, it is a good return; but I am attaching high negative downside so the expected return isn't as good. I wasn't too keen on a 5% return for risk arbitrage.

In the end, I decided to take a position. The underlying business is great--there are only 3 or 4 other businesses like this at this scale in the world--so even if the deal fails, I would rather own this than many other companies out there. If the deal fails, because I am buying at a high price, the return won't be that great. But this company will be profitable and will be around for another 25+ years (same can't be said of many risk arbitrage companies I take positions in).

The main risk with this deal is the uncertainty over the EU government regulator approval.

The structure of this deal is a bit different from most large mergers one may be familiar with: this is a tender offer by ChemChina so shareholders need to submit their shares once approval granted. As usual there are squeeze-out provisions.

NOTE: All figures refer to Syngenta ADS trading on NYSE. Arbitrage spreads may be slightly different for the actual shares trading on the Switzerland SIX exchange.

Takeover price: $92.95
(tender offer of $93, less $0.05 ADS fee; possible additional $1 per ADS dividend with shareholder approval but I'm ignoring this since I'm uncertain)

Deal closing: 2nd half 2016

Purchase price: $85.22

Prob (success) = 90%
Return  (success) = 9%
Prob (failure) = 10%
Return  (failure) = -35% (assume it drops close to 5-year low of $55)

Expected Return = 5%

As stated above, the expected return isn't that great (although it's good if deal closes this year), but I decided to take a position due to the strong underlying business with good long-term macro background. In fact, I'm thinking of whether to increase my stake early next week.

Buffett's Four Key Questions

(1) How likely is it that the promised event will indeed occur?

Most regulatory agencies have approved (including CFIUS--not too relevant here) but the main approval from European Union is pending. Numerous analysts have commented that the assets of Syngenta and ChemChina do not overlap. The Morningstar analyst report I have access to--the only one freely availabe via my discount brokerage--mentions that combining seeds and crop chemicals likely won't lead to monopoly-like competitive advantage and minor divestitures (if required) should appease regulators. The analyst also suggested that the risk of successful deal closure has declined a bit due to multiple agro-chemical deals on the table (Bayer buyout of Monsanto; Dow Chemical and Dupont merger; and this ChemChina buyout of Syngenta). Morningstar estimates 75% probability of deal closure.

I feel that the probability of success is closer to 90%. I think the businesses don't overlap so there isn't a natural regulatory concern (EU might still be concerned with a Chinese takeover of their premier agri company but China is large future agricultural market and this will enable the company to meet those demands more easily.) Financing doesn't seem a risk given how some news reports suggest that ChemChina has already lined up most of the funding (and the Chinese government has pushed ChemChina to merge with SinoChem to improve the balance sheet). This recent Reuters article is a good summary of the various items. There is a large $3 billion break-fee that ChemChina would have to pay Syngenta so I believe there is high motivation by the bidder and their investment bankers to close the deal.

(2) How long will your money be tied up?

The deal has been extended several times and it is expected to close by the end of this year. Reuters article suggests that the earliest EU decision might be Oct 28. However, there is the possibility of final ruling dragging on for months, especially if divestitures or some other business restructuring is required. I think worst case date for closure might be 6 moths from now (say Q2 2017). If the deal closes by the end of this year, the expected return of 5% is attractive; but if it go to Q2 2017, it isn't such a great return (although if you are bearish like me, it's decent for something not correlated with the market).

(3) What chance is there that something still better will transpire - a competing takeover bid, for example?

There was the Monsanto-Syngenta discussions in 2015 that went nowhere. So there is some remote possibility of a better bid but given the size of the company involved, I don't expect anything better.

(4) What will happen if the event does not take place because of anti-trust action, financing glitches, etc.?

Not that one should blindly follow Wall Street analysts but just to give an idea, Morningstar values Syngenta at $78 if the deal does not close (about -10% from here). I have to look into it in more detail and don’t want to go into too much right now, but I did look at this company briefly (not written up on blog) 5+ years ago. I was investigating Bunge as a potential investment and looked at the major agri businesses in the world including Syngenta and Monsanto (as usual, both of these were too expensive). The Swiss-based Syngenta is one of the premier non-commodity agri businesses in the world (top 2 at that time in my opinion, and probably still in the top 3) and is hard to replicate.

At current price, Syngenta's P/E is around 30 and forward P/E is around 20, with P/FCF around 30. Obviously the valuation is really high, which is usually the case when you are buying close to a takeover price. ROE has trended down recently but its 10-year average is around 18%. In the commodity complex, which I have been bearish on for years, agriculture is probably the one with the best future outlook given increasing incomes and population in developing countries (in contrast, oil & gas, base metals, etc, are still a big question mark right in my opinion.) Syngenta isn't a commodity company but it is influenced by the agricultural commodity complex (i.e. if prices of, say, corn or wheat rise, companies like Syngenta, Monsanto, etc will do better). Even if the deal fails, this is one company I wouldn't mind owning (albeit not at this price). In the worst case, I think the share price might fall somewhere near its 5-year low, maybe around $55 (-35% from current price).

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Monday, October 17, 2016 0 comments

Bloomberg's Henry Kravis Interview (June 2016)

I'm back to blogging--I think.

Anyway, I was reading this Bloomberg interview with private equity pioneer, Henry Kravis, and found it interesting. I don't follow private equity and don't really have much in common but it's remarkable how their thoughts and approaches apply to small investors as well (obviously everything doesn't apply so one can't apply everything). It's a pretty good interview so do check it out if you have some time to kill. (As long-time readers may be familiar, anything in square brackets is by me and bolds are typically mine.)

(Photograph by Daniel Shea for Bloomberg Markets, June 13 2016)

JK [Jason Kelly, Bloomberg journalist]: What’s changed in those 40 years [since KKR was founded]?

HK [Henry Kravis]: There’s money everywhere today. There’s almost no institution in the world—whether it’s a sovereign fund, a foundation, an insurance company, banks, pensions funds—that doesn’t do something in the private equity sector. Information today is better than ever before. Markets are pretty darn good. There’s so much more transparency. Which also means our business has much more competition. I sort of liked it when it was just us.
On top of huge money printing by central banks--maybe I'll get to this in a future post--a big difference nowadays is that practically everyone is investing money in stocks. This is one reason I suspect we will enter a big bear market (when everyone is overloaded in one direction, it will swing the other way eventually).
JK: Buy-slash-and-sell is the typical perception of the private equity industry. How do you think of yourselves at KKR?

HK: We like to think of ourselves as industrialists. I’m using industrialists in a broad sense. We buy a company and look at what we can do to make it better. How can we improve operations? Maybe it’s fixing the pricing or the supply chain, or putting the proper metrics in place so we can better measure what the company is doing. Maybe we have to change some of the company’s management. And understand that we are long-term investors for the most part. Our average holding is seven years. To me, there’s so much more to investing than buying low and selling high.
I consider 10+ years to be long-term and wouldn't really consider 7 years to be a very long-term. However, given how short-term-oriented the market is right now, KKR holdings do look more long-term than the rest. According to this Jason Zweig article in The Wall Street Journal, NYSE average holding period in 2015 was only 19 months (63% turnover!!) and mutual fund turnover in 2015, according to Morningstar, was very similar at 66%! From a long-term historical perspective, these figures are extremely low and "off the charts". Brokers, HFT funds and others charging commissions are probably making a killing right now.
JK: What’s the most surprising thing you’re doing as an investor?

HK: We did only private equity until 2004. We’d go see a company and by about the third sentence somebody on our team would ask, “Is your company for sale?” And the CEO would say, “We have no interest in selling.” And our team wouldn’t have much more to say after that.

Today KKR is in three broad buckets: private markets, public markets, and capital markets. Private equity is probably 40 percent of what we do, and the rest is these newer businesses, which are all growing very well.

We didn’t start off thinking we would be in the credit business, or real estate, or hedge funds. This is an evolution. We didn’t do any of this overnight. It took a long time. In the process we became much more of a solutions-provider that can invest up and down the capital structure as opposed to a pure private equity investor. So we never have a conversation that begins and ends with, “The company’s not for sale.” Now we start off with, “What do you need today that you’re not getting?”

JK: Did you miss deals because of that?

HK: In 2002, I remember going to see an energy company called Williams, in Oklahoma. I’d grown up with the Williams family in Tulsa, and they were having some financial difficulty and needed to restructure their balance sheet. We said, “Why don’t we buy the company, take it private, and as part of that we’ll restructure the balance sheet?” They thought about it and decided they didn’t want to go private. So we said, “All right, let us provide you with a structure that can fix your balance sheet.” They thought about what we gave them and said, “That’s a great structure, but we have no money for this.” They ended up taking the exact structure we gave them and calling Warren Buffett. After about five minutes, Buffett said, “This is a no-brainer,” and he did the deal. We decided right then that KKR needed to get into the credit business.
Funny how Warren Buffett always ends up in stories, most unexpectedly. Anyway, it is interesting to hear how private equity is picking up lending/loaning/credit where banks have withdrawn. Stricter regulation has forced some banks away from credit and this may be bad for bankers and their shareholders but it is good for society. It would be much better if banks went bank to traditional businesses and avoided certain types of risk. Kravis does suggest that banks have withdrawn from small and medium businesses and that sounds bad but if those not profitable given their risk profile, that's fine IMO.
JK:When you think about how deals are done today compared with back in the day, how are things different?

HK Well, we used to be able to put up a dollar of equity and borrow $20 or $30 to buy a company. When we bought Safeway in 1986, it was about $5.3 billion, and we put up about $123 million of equity. When we bought RJR Nabisco, originally we put up $1.3 billion of equity against $30 billion of total purchase price. But today, that’s all changed. You put up a dollar of equity and borrow a dollar of debt, maybe two, depending on your total earnings. So the capital structures have changed entirely.
Interesting to hear how it was easy to leverage up 20x to 30x the equity in the 1980's when interest rates were really high whereas now they can only borrow 1x to 2x. I didn't know these funds were able to borrow so much back in the 80's. No wonder the successful ones made so much money so quickly. I wonder if the massive bull market in bonds facilitated this (recall how, at that time, long duration bonds were making as much money as stocks (due to capital gains arising from falling interest rates)).
JK: How does that change you as an investor?

HK: When you buy a company, obviously you’ve got to look at the price you’re paying. One thing that’s different from the 1970s and the 1980s is that the valuation of companies has changed significantly. So we look at where the industry is going, and we look at the downside.

JK: Where did you learn that?

HK: When I was in my early 30s at Bear Stearns, I’d have drinks after work with a friend of my father’s who was an entrepreneur and owned a bunch of companies. “Never worry about what you might earn on the upside,” he’d say. “Always worry about what you might lose on the downside.” And it was a great lesson for me, because I was young. All I worried about was trying to get a deal done, for my investors and hopefully for myself. But you know, when you’re young, oftentimes you don’t worry about something going wrong. I guess as you get older you worry about that, because you’ve had a lot of things go wrong.
Same thing that Benjamin Graham and Warren Buffett and Charlie Munger and Howard Marks and Martin Whitman and numerous others keep saying. Unfortunately, I, and many others, have a habit of ignoring this and getting in trouble. I need to keep reminding myself to always consider the downside.

Final words...
HK: Also, if I can take one thing other than integrity and instill that in people, I’d want it to be curiosity. Because to me, people who are curious are going to be better investors and better stewards of others’ money. If there’s no curiosity, you’re basically doing something that’s already been done by someone else.

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Saturday, October 1, 2016 0 comments

Purchase (Liquidation): Khan Resources (KRI)

Likely return on this is very small but thought it was worth taking a position...

I was reading this article on Bloomberg on Mongolia and it mentioned the mining license dispute with Khan Resources (CSE: KRI) that was finally settled by the Mongolian government. Now that the company has received the settlement, it will be liquidating itself and distributing its holdings to shareholders. I was evaluating it and following it for about a month before taking the plunge now.

Based on some liquidation value calculations I did a while back--basically discounting assets and applying estimates of liabilities for liquidation--I arrived at a liquidation value of C$0.93 (calculation at bottom but final payment likely much lower). However, the company finally issued a press release on Sept 13 2016, estimating final liquidation value between $0.86 and $0.93. Shareholder vote will be held on Nov 10 2016 (record date Oct 4 2016). They will pay out $0.85 right away after the vote so the risk of capital being tied up is zero.

If you buy at $0.86, you are looking at around 0% to 8.14% return (excluding transaction costs and taxes). If you think you will receive around the midpoint of management's estimate, you are looking at around 3.49% return. (It's not easy to buy at $0.86 but it can be done; If you buy at $0.87, you will earn about 1% less with a potential for a loss of -1.15%.

Purchase Price: $0.86

Discounted Book Value (from Q3 2016, filed Aug 19 2016) [note: excl future Netherlands transaction])

(all in thousands)

Cash $87,164.00

Investments (@50%) $161.00
[listed Plateau Uranium, penny stock with low volume but likely can be sold over a period]

DEDUCT: Total Liabilities -$950.00

DEDUCT: cash from sale of Bermuda  -$2,361.44
[Aug 17 2016 Bermuda sale transaction sold for less than cash. Management acknowledges it. -- subsequent event after June period, Aug31: USD/CAD rate of 1.3050; was 1.2942 in last financial statements]

DEDUCT: Future corporate expenses until wind-down (estimate) -$1,500.00
[wild guess]

ADD: Inflow from employee options exercised $1,070.50
[refer to note 9 in Q3 financials for detailed option breakdown and average exercise price]

Net assets discounted $83,584.06

Shares Outstanding (Aug 24 2016 according to Khan website)
90,166,482 [fully diluted (incl assumption options exercised)]

Estimated liquidation value $0.93 [note: this was before company released its estimates; I expect final payment to be less than this]

Side note 1: Cancelling mining permits, often under dubious reasons of not meeting environmental or some related conditions, is one way foreign countries seize assets from investors (usually after a lot of hard discovery work has been done and a resource like gold or oil has been discovered and proven). Some may recall how the Russian government strong-armed BP, one of the largest oil & gas companies in the world, over environmental permit issues. Well, it's even worse for smaller companies. Mongolia basically took away the rights of Khan Resources and basically bankrupted the company (although there was a settlement in the end--too late for prior shareholders though). They also had a very serious dispute with Ivanhoe Mines (Turquoise Hill Resources) and Rio Tinto over the massive gold/copper deposit Oyu Tolgoi.

Side note 2: I never even knew there was a new exchange in Canada but KRI trades on the upstart Canadian Securities Exchange.

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