Updated Market Thoughts

I have not written a post in over a year about the overall market. For nearly two years the market climbed higher despite extreme sentiment readings, with only minor blips along the way. Historically, Investors Intelligence bears readings below 20% were a warning sign.  Yet for the better part of two years Investors Intelligence bears were under 20% with no repercussions. There are numerous such examples. After a while I decided to stop pissing in the wind and stopped writing posts about the extremes in sentiment. With all the nervousness out there (myself included) I thought this would be a good time to update my market thoughts.

I believe the reason sentiment stopped working was that corporations have been providing a steady bid in the market through share repurchases and cash M&A. In the past couple of years corporations finally started to use the nearly free money in the bond market to lever up in earnest. I believe this steady bid from corporations combined with a positive feedback loop from investors has led to this steady grind higher. I would note that the S&P 500 has outperformed both small caps and international equities, as the bulk of share repurchase and cash M&A occurred in larger cap US stocks.

The good news is that the backdrop of corporations using cheap money to purchase stock is still in full force. Corporations are still able to borrow cheaply and are doing so.  In a recent three week period about $60 billion of cash M&A was announced, while the steady repurchases largely continue. The economic backdrop of steady yet uninspiring growth continues as well.

The bad news is that investors have grown complacent after two years of relatively little pain. Individual investors have historically high allocations to stocks, margin debt is at a record and I have heard endless stories of institutional allocators in search of more beta.  It appears that this positive sentiment is being unwound and given the aggressive positioning of the investment community there could be more to come.


If the unwind of excessive sentiment continues it is likely to trump corporate buying in the near term and the sharp, painful correction is likely to continue. However, over the medium term the steady bid from corporations is likely to assert itself again. Corporate buying combined with positive seasonality starting in November, make it likely that near term losses would be recuperated over the next few months. But in the interim it could get ugly and a few more sleepless nights may be ahead for investors. 

My Trip To the Crimson Wine Group Annual Meeting

I recently attended the annual meeting of Crimson Wine Group, the owner of 5 wine estates that was spun off from Leucadia in 2013. In the tradition of Leucadia, Crimson does not communicate with Wall Street. There are no earnings press releases, conference calls or presentations and management does not take phone calls. The only way to get information from Crimson is through their SEC filings. When I heard that Crimson would have a Q&A at their Annual Shareholders Meeting I decided to make the trip to Napa as I had a number of questions for management.

The annual meeting took place in a wine cave at the Pine Ridge estate. Ian Cummings (Leucadia co-founder) was supposed to host the event but due to a surgery Joseph Steinberg (Leucadia co-founder) did so in his place. Joseph Steinberg has a reputation for being the bad cop to Ian Cummings good cop and he lived up to his reputation. When asked why Crimson was spun off he answered, “because we wanted to”. Management declined to answer many of the questions but I learned a good deal about the company none the less.

The first question I asked the CEO was about a newspaper article that quoted him as saying that he wanted to reach $100 million in revenue by 2016. He seemed to back off that statement and said that he wished he did not say it. In addition, Joseph Steinberg emphasized numerous times not to have too high expectations for the short term as progress in the wine business takes time.

The most important piece of information I came away with from the meeting was finding out why Joseph Steinberg believes Crimson is a good investment. Joseph Steinberg alluded to the private market value of the wine estates being well above the GAAP book value. He called Napa the Hamptons of the Bay Area and noted how much prices have gone up since they purchased the estates. He also noted that as the Hamptons of the Bay Area, Napa/Sonoma real estate prices are likely to continue to rise over time. Steinberg views the rise in the estate values as part of his profits in addition to the profit of the actual wine business.

When an attendee asked Joseph Steinberg to value the five wine estates he replied “I’m not going to give you the NAV. You’re an analyst. I’m sure you can figure it out for yourself”. As an analyst I have taken many stabs at trying to figure the value of Crimson’s five estates and I believe that they are conservatively worth $15.50 a share (likely more). Assuming 3% a year asset appreciation on $15.50 of assets yields an additional 5% a year of return in asset appreciation on top of any earnings (at the current stock price). 


Joseph Steinberg spent most of the meeting playing down expectations and noting that progress takes time and patience in the wine business. However, he ended the meeting with a vote of confidence for the stock telling shareholders “we will get rich together slowly”.

Crimson Wine Group Asset Value

Valuing Crimson Based On Assets
Crimson has a stated book value of $8.12. However, this does not take into account the value of two of Crimson's most valuable estates. Crimson acquired Pine Ridge in 1991 and Archery Summit was started in 1993. These two estates are carried for next to nothing on Crimson's book due to GAAP accounting. In 2001 these two estates were put on the market for $150 million as seen in this Wine Spectator article. It makes little sense that they are assigned almost no value.
Napa Valley estates trade at record prices and at significantly higher prices today than they did in 2001. It is estimated that the Araujo Estate in Napa recently sold for over $100 million (or $2,630,000 per acre) . Araujo, has 38 acres and produces approximately 6,000 cases a year. Inglewood Estate, recently sold for an estimated $20 million (0r $666,000 per acre). Inglewood has 30 acres and produces 5,500 cases. The new owners are rebranding the estate suggesting weakness of the Inglewood brand.
Pine Ridge, which is located in Napa, currently produces 80,000 cases a year and has 168 acres. Pine Ridge has an additional 46,000 cases of capacity. Inglewood'd brand is clearly is clearly inferior to that of Pine Ridge. At Inglewood's valuation ($666.6 k per acre) Pine Ridge would be valued at $112 million. At Araujo's valuation ($2.63 million per acre)Pine Ridge would be worth $442 million. The answer to Pine Ridge's valuation likely lies somewhere in between. I believe that Pine Ridge alone could be sold for at least $200 million.
Archery Summit is the premiere estate in Willamette, Oregon. Archery Summit has 100 acres and produces 15,000 cases a year. Archery Summit is able to charge $150 for its Pinot Noir, far more than any other winemaker in the region. I estimate the value of Archery Summit to be $20 million.
Crimson's purchased its three other estates in recent years. Seghesio was bought for $86,000,000 in May 2011 and is located in Sonoma. Since then the value of Sonoma estates have risen significantly. Additionally, Crimson expanded capacity and has grown sales at Seghesio. Seghesio would likely sell today for over $100 million. Chamisal was bought for $19,200,000 in August of 2008. The purchase price of Double Canyon in 2005 and 2006 was undisclosed but I estimate it to be worth at least $10,000,000. Crimson recently sold land that it was not using at Double Canyon for 70% above book value. It is possible that even the land that Crimson bought in recent years is being carried drastically below market value.
The table below summarizes my estimate of the value of Crimson's wineries:
WineryValue
Pine Ridge / Archery Summit$ 220,000,000
Seghesio Family Vineyards$ 100,000,000
Chamisal Vineyards$ 19,200,000
Double Canyon$ 10,000,000
Total$ 349,200,000
Adding my estimated land value to the $30 million in cash & investments Crimson will likely have at the end of this quarter yields a tangible book value of roughly $15.50, or a price 75% higher than the current quote.

Dow Chemical's Risky Gambit

THE REPURCHASE

Dow Chemical announced that they will repurchase $4.5 billion worth of stock over the course of 2014 amounting to roughly 8% of the float of the stock at the current price. The vast majority of this repurchase will be done with borrowings as there will likely be very little cash left over after capital expenditures and dividends. Share repurchases of this size are generally very bullish for the near term performance of a stock but there is more than meets the eye to this repurchase.

THE CONVERTIBLE PREFERRED SHARES

In 2009 Dow issued a total of $4 billion in convertible preferred shares to Berkshire Hathaway and Saudi Aramco (SA) in order to complete their acquisition of Rohm & Haas. These shares pay a preferred dividend of 8.5% and have a strike price of $41.32. It is unlikely that Berkshire or SA will opt to convert these shares because of the hefty dividend and the value of the call options. However, this large dividend is burdensome to Dow and Dow can force conversion if the common stock price exceeds $53.72 per share for any 20 trading days in a consecutive 30-day window. I believe this share repurchase is essentially a risky gambit to force conversion of these preferred shares. If this plan is successful then there will actually be more shares outstanding following the plan than before the repurchase.

THE RISKS

On the surface this plan appears to be sound as it removes burdensome preferred shares paying an 8.5% dividend and replaces it with cheaper debt. The risk is that the plan fails (ie. Dow can’t force conversion) and that Dow enters the next down cycle with an additional $4.5 billion in debt, the burdensome 8.5% preferred and an enormous pension gap that would likely balloon further. It seems that Dow has the debt coverage ratio to take on the additional debt but that ignores the gaping pension hole and the likelihood that EBITDA would contract dramatically in a cyclical downturn. I am not predicting a cyclical downturn but noting the risks if it does occur.

THE OUTLOOK

My experience with share repurchase of this size is that they are positive for near term performance even if they are not in the best long term interest of the company. However, once the stock price approaches $53.72 Dow becomes a compelling short. In addition to the very rich valuation there would likely be enormous selling pressure at that price. At that price Berkshire and SA would need to start selling down shares unless they want to be owners of Dow Chemical stock. If Berkshire & SA sold down their stake it would amount to over $5 billion, greater than the amount of the Dow repurchase. It is also possible that funds aware of this situation would sell ahead of that price.

MY PLAN


Dow Chemical is one of five chemical stocks I am short against Eastman Chemical, a stock I believe is far more attractive. As a result of the share repurchase announcement I covered a portion of my Dow short despite the fact that I believe shares are overvalued. I don’t want to stand in front of an 8% repurchase as there is no money in being a martyr and I want to be in a position to short with reckless abandon if the shares approach $53.72.

Dow Chemical Is No Bargain

Dow Chemical is one of five chemical stocks that I am short against a long position in Eastman Chemical, a security that I believe is far more attractive (I explain my long case for Eastman in this article). In light of the Third Point letter on Dow Chemical I want to explain why I view shares of Dow as relatively unattractive.

Valuation

Dow Chemical trades at an expensive valuation compared to its chemical sector peers. As seen in the charts below, Dow has one of the lowest EBITDA margins in the chemical sector yet trades in the middle of the group in terms of valuation.




This comparison is generous to Dow as it ignores Dow’s $9 billion unfunded pension liability. If one includes the pension deficit in Dow’s enterprise value than EV/EBITDA is roughly 10 times. This adjustment puts Dow squarely in the high end of valuation versus its chemical peers despite a low quality mix of businesses.  An analysis based on P/E ratios would make Dow look even more expensive.

Turnaround

The Third Point letter points to “cost cutting and operating optimizations that could amount to several billion dollars a year in annual EBITDA”. Dow Chemical has announced multiple restructurings & layoffs over the years leading to the lowest SG&A/sales ratio in the chemical sector. Dow’s SG&A is only 5% of sales. This suggests limited room for margin improvement through cost cutting. Where else will the cost cutting come from if not from SG&A? Are they running their crackers inefficiently? Are they selling commodities at below market prices?

The Third Point letter gives no details of what operating optimizations could save billions so it is difficult for me to refute that point. However, later in the letter Third Point complains about “poor segment disclosure combined with Dow’s opaque and inconsistent transfer pricing”. This is seemingly contradictory. If Dow’s disclosures are poor, than how can Third Point be certain these optimizations are possible?

Spinoffs & Asset Sales

Justifying a high price target for Dow Chemical involves placing a premium multiple on every business line (while ignoring the pension deficit). If one takes any diversified chemical company and puts rich multiples on every segment than all of them will look cheap, with tremendous upside. There is no reason to believe that Dow will achieve these rich multiples. Proponents of Dow point to spin offs and asset sales.

It is unclear to me why spin offs will help Dow as their blended businesses already trade at relatively high multiples. Axiall, which is the comp for the business Dow is planning to spin off, trades at only six times EBITDA. Dow owns numerous low margin, commodity businesses that deserve to trade at low multiples. With Dow trading at roughly 10 times EBITDA (including pension) that means that the rest of Dow trades at well over 10 times EBITDA. Secondly, why would these spin-offs trade for best of breed multiples if they don’t perform like best of breed businesses?

Significant asset sales seem like a pipe dream as well. Dow and Dupont are the two largest US chemical companies. Both have activists and both are looking to sell assets. If the two largest companies are sellers, who will the buyers be? It is possible that Dow and Dupont will find buyers for some businesses but any sales are unlikely to be significant to either company.

Summary


Dow Chemical appears to be among the most overvalued chemical companies relative to its peers. Spinning off a business is not a magic elixir that turns around a business. There are higher quality companies with great managements available at cheaper multiples (see Eastman Chemical). A fixer upper is not always a great deal and can often be a money pit.

Four Investment Ideas With Upcoming Catalysts : Part 2

In this two part post I outline four value investments that I own with catalysts in the first quarter of 2014.  In part 1 of this post I reviewed Air Products and Chemicals (APD) and Annaly Capital Management (NLY). Here are my final two picks:


Eastman Chemical (EMN)
Catalyst: Aggressive share repurchase plan starting in Q1 2014

I laid out a detailed case for owning Eastman Chemical in late October. In summary, over the past decade Eastman has transformed itself from a maker of commodity chemicals into a specialty chemical maker with among the highest margins in the group. Specialty chemical makers tend to trade for a large premium to their commodity peers yet Eastman is among the cheapest stocks in its sector. Eastman has one of the highest free cash flow yields, lowest P/Es and lowest EV/EBITDA ratios in the chemical sector.

Eastman has spent the past few quarters paying down debt that resulted from an acquisition and will be done paying it down by the end of 2013. I believe that starting in the first quarter of 2014 Eastman will direct free cash flow towards shareholders in the form of an aggressive share repurchase.

Eastman management has stated numerous times that they will use their balance sheet and ample free cash flow to reach their earnings goal of $7 in 2014 and $8 in 2015. They have also said that acquisition targets are too expensive now, which points towards share repurchases to increase earnings. Management also mentioned in passing on a recent webcast that share repurchases have a larger effect on EPS when done earlier in the year. This leads me to believe that Eastman will start repurchasing shares aggressively in the first quarter of 2014, getting the ball rolling on a re-rating of the stock. I am long EMN short ALB CE DD DOW FMC

Muni Bond Closed End Funds
Catalyst: End of tax loss selling

Municipal bond closed end funds (muni CEFs) are down as much as 30% from their highs in some cases. Fed tapering and headlines from Puerto Rico and Detroit have brutalized the municipal bond market and muni CEFs even more so. This leaves many muni CEFs trading at high single digit discounts to NAV and yielding nearly 7%, which is the taxable equivalent of over 10%.

I believe that scary headlines like those in Puerto Rico and Detroit are outliers. For the most part municipal finances have improved over the past year as tax receipts have grown along with the economy. One could even argue that municipal bonds value versus treasuries should be higher than ever as tax rates are higher so the tax advantage has grown. Municipal bonds offer the best after tax, risk adjusted return of any asset class. Once tax loss selling ends the market should begin to recognize this. I am long NRK VMO VKQ PMO NAN

Four Investment Ideas With Upcoming Catalysts : Part 1

Earlier in the week I outlined the difficult environment facing value investors. Finding new investments meeting a value criteria has not been easy after a nearly tripling of markets in less than five years. A couple of months ago my cash pile was growing as many of my investments reached their target and I could not find new investments to replace them. Much to my own surprise I have recently been able to put money to work and am excited about my portfolio. Four of my investments, which I will outline, have catalysts coming up in the first quarter of 2014.

Two of the investment ideas came along as a result of tax loss selling. Tax rates have gone up this year and many market participants have large gains. Those looking to offset gains with losses have very few choices this year, so a small group of losing stocks have bore the brunt of this selling. Tax loss selling is similar to forced selling in that sellers are not basing their sell decision on the merits of the stock. The good news is that there are less than four trading days left in the year and tax loss selling will soon be over. The other two ideas are are long/short ideas with company specific catalysts. Without further ado here are my four investment ideas:

Air Products and Chemicals (APD)
Catalyst: Announcement of new CEO

Bill Ackman took an activist position in Air Products and Chemicals earlier this summer. He was quickly able to gain board seats and remove the CEO. Normally, this would cause the stock to fly but due to the adverse publicity Bill Ackman has received from Herbalife and J.C. Penney the stock has barely outperformed its peers. Bill Ackman has had many successful activist campaigns and a small handful of failures. Air Products and Chemicals has a lot more in common with his successful campaigns.

Air Products has strong, recurring free cash flow that is being masked by a capex binge. Only $300-$350 million of Air Product's $1.52 billion a year in capex is maintenance capex, while the rest is expansion. New plants take three years before they are built and operating at the capacity needed to create strong cash flow. The benefits of the capex binge of the past few years has not been realized but will be realized over the next few years, resulting in higher cash flow. The new CEO is likely to reduce capex spending on new projects and direct more of free cash flow to investors.

Air Products has the lowest margins in its industry. It largest competitor, Praxair, has margins nearly 50% higher. There is a lot of room for cost cutting and increased sales productivity to improve margins. With modest margin improvement and the realization of the benefits of their capex binge, Air Products could see over $14 in free cash flow per share annually some time in the next few years.

Many people I have discussed Air Products with have been scratching their heads as to why Bill Ackman has chosen the company. Bill Ackman has still not laid out a detailed case for this purchase,as he is likely waiting for the new CEO to be announced. A new CEO has not been chosen yet but is likely to be chosen in the first quarter of 2014. The appointment of the new CEO is likely to act as a catalyst for the stock as the new CEO lays out his strategy and Bill Ackman lays out his investing case. I am long APD / short PX ARG

Annaly Capital Management (NLY)
Catalyst: End of tax loss selling

I recently laid out a detailed case for owning Annaly Capital Management. In summary, Annaly trades for an unwarranted 20% discount to book value. Annaly has lowered leverage, hedged and diversified into commercial mortgage backed securities. Annaly is positioned well to withstand  future interest rate increases with minimal damage to book value. I believe the reason for this deep discount is primarily end of the year tax loss selling and the fear of the effects tapering will have on Annaly's book value. Tax loss selling will soon end and as time passes the market will eventually become more comfortable with the effect tapering has on Annaly's book value. I am long Annaly.

Click here for part 2