Reinventing The Death Spiral

April 9, 2017 11:47 PM


About two decades ago, some unscrupulous hedge funds began tricking unsophisticated small cap companies into agreeing to “death spiral” converts (convertible debt). These were called “death spirals” as there was no set floor to the conversion price. Rather, they converted at some date in the future based on then market prices. Despite promising not to, these funds immediately began shorting shares with the goal of destroying the share price and converting as low as possible in order to take control of the companies, or at least get large share ownership positions. Oftentimes, a few million dollar “death spiral” convert would end up costing management the majority of their company. Along the way, my fund sometimes shorted these “death spiral” stocks as you knew that the hedge fund owning the paper would keep leaning into it until the conversion date. Furthermore, any intelligent long would sell and move on—as you just can’t do business with someone too stupid to not understand how these things worked. Without logical buyers and a wall of stock on the offer, they were as close to layups as you could get in finance.

Since then, corporate boards have wised up and you seldom see these “death spirals” any longer. Of course, in finance, there are rarely new inventions—rather, creative finance types dust off old tricks and re-imagine them. Therefore, you have to have a certain respect for CEO George Economou from Dryships Inc (DRYS: Nasdaq) as he took the “death spiral” and added a unique spin to it. In the Economou version, he “death spirals” his own stock through an independent party named Kalani. DRYS has now undertaken a few variations of this theme, but the basic underlying trend is that DRYS sells shares to Kalani at a discount to market and Kalani then sells them into the market as rapidly as possible so that Kalani can reload and earn the spread between the price they buy them from DRYS at and what they can sell them for. In the process, the share price of DRYS has been in freefall.

DRYS

Now, you have to be asking the question; why would Economou want to purposefully crash his share price? I don’t think he cares what happens to the share price, beyond propping it up sufficiently to sell more shares. His goal is to load DRYS up with cash from the share sales so that his private entities can extract value through fees and asset sales to DRYS at inflated values. It’s a unique spin on the host-parasite relationship.

Of course, the next obvious question is; who the hell keeps buying this stock if you know that he’s going to keep reloading for a few hundred million dollars in share sales each quarter? Now, here’s where you have to admire Economou, while I’m sure some poor retail guys haven’t read the fine print and got thoroughly abused, my hunch is that most of the buying is coming from various quant funds. You see, these funds are run by computers and they look for underlying fundamental values like; price to NAV, price to cash flow, revenue growth and cash flow growth. These computers aren’t yet smart enough to read the fine print and understand what Kalani is doing—in fact, the various Kalani deals do not look all that different from an equity line of credit, convertible bond or at-the-market offering. Optically speaking, DRYS trades at an obscene discount to NAV and revenue is growing as is cash flow. The computers are short-circuiting themselves to buy this thing as it looks cheap. Even crazier is the lag between when the share sales happen and when they’re reported. If you were buying on Friday, you would have thought that the share count was around 152 million—nope, 36 million shares were sold since the last reported share count and the new share count is 188 million. The computers are using the wrong data inputs as they’re programmed to assume that a company is trying to create shareholder value or at least not destroy it on purpose. Economou’s trick is to sell shares at such obscenely cheap values that it continues suckering new buyers into DRYS shares.

In finance, no lucrative scheme can go on for long before imitators show up. Since DRYS started its “death spiral”, Diana Containerships, Inc. (DCIX: Nasdaq) announced their own version of the “death spiral” using warrants. I’m sure others will follow. I bring this all up because no one should lose money for not reading the fine print—if you own either of these, be wary. Never simply assume that management cares about you as a shareholder. Much more importantly as more “death spirals” are created, there are lots of opportunities to profit on the short side. I don’t normally short stocks, but in these situations that are designed to fail, I cannot help myself. I’m playing small and expecting some epic short squeezes along the way.

I suspect that shorting these "death spirals" will continue to be a lucrative little venture over the next few quarters. Please share with me if you see any new death spirals announced.

Bombs away!!!

Disclosure: I am short DRYS and DCIX.

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Hasta Luego Mexican REITs

March 9, 2017 1:27 AM


Him: I think people are wrong. There are lots of instances where the Fed has raised rates and nothing bad has happened.

Me: Name one time.

Him: hmmm…. Oh crap!!

Yea, we’re getting to that moment where people realize that rates may finally matter in a highly leveraged economy. My good friend Tal, made that point over a year ago.  I hope you took his warning and lightened up on interest rate sensitive assets.

Let’s think of a typical REIT called Ponzi REIT (Ticker symbol PREIT). They’ve been out there for nearly a decade, buying “irreplaceable” Class A assets in “gateway cities.” Every six months, they raise money to buy more assets and through a combination of financial engineering and deferred maintenance, they manage to increase incremental AFFO per share on each transaction. So what if they’re overpaying--buying 4-cap assets if they can fund them at a 3% financing cost—it’s still accretive to the dividend.

Ignoring working capital and taxes, the current balance sheet is $10 billion in assets at cost offset by $5.5 billion in debt for total debt to capital of 55%. So far, it looks like pretty much every property REIT out there. At a 4 yield, they have $400 million of operating income and $165 million of interest expense, for total AFFO of $235 million. They trade at a 4% dividend yield or a $5.875 billion market cap. By magic, $4.5 billion of equity is worth 31% more than book. We’ve covered this before in my section on Ponzi MLPs last year. As always, it’s highly lucrative for investors to continue this charade with future capital raises, until it isn’t.

Now, interest rates are rising. Let’s say that PREIT’s assets are no longer valued by the market as 4-caps, but are instead 6-caps. Keep in mind that this would still be dramatically below average cap rates over the past few decades. Now, the $400 million in operating income is only worth $6.667 billion and with $5.5 billion in debt, total debt to capital is 83%. That’s a VERY leveraged balance sheet. Even worse, the assets are funded with 5-year paper. When that re-sets to 5% interest rates, interest expense bumps up to $275 million a year and AFFO declines to $125 million a year. At a new market 6% dividend yield, this is now only worth $2.08 billion. Essentially, a small change in interest rates just destroyed 65% of the equity value of PREIT.

All of this assumes that the revenues at PREIT stay the same. What if rents decline? It’s no secret that there’s a massive oversupply of commercial property being built. If rents or occupancy decline, you could be looking at a situation where dividends could be cut. Heck, interest coverage itself may come into doubt. I know that lots of investors keep talking about interest rates not mattering in the property sector because rents will go up with a stronger economy. Rents will need to go up a whole lot to keep pace with cap rates going from 4 to 6. We all know that isn’t going to happen. Especially in sectors like retail where tenants are increasingly downsizing. Finally, REITs are unusually bad vehicles for dealing with debt re-payment when the ponzi scheme goes in reverse as REITs cannot retain earnings to de-lever and instead must raise capital by issuing equity--often at highly disadvantageous prices. At least MLPs were able to cut dividends and de-lever. Look at 20 year charts of many large REITs. Notice how long it took them to recover from the highly dilutive equity raises that most undertook in 2008 and 2009.

Of course, I’m not the first guy doing this math. Look at the charts of various smaller REITs that aren’t being propped up with broad market ETF inflows. These things are getting nuked—particularly in the retail sector. I suspect that this contagion eventually spreads to other REITs as well. Where will they bottom? My guess is a whole lot lower and this will put stress on many other sectors of the economy. For instance, it is still a head scratcher why banks have recently been so strong, as they will bear the brunt of this decline in asset values.

I continue to have very few long positions and continue to wait for bargains. As I survey what few positions I have, I realize that I don’t want property assets—even if they’re dramatically undervalued and underleveraged Mexican hotel REITs that will benefit from a weaker Peso. If REIT investors start to liquidate assets, nothing will be immune. Over the past few days, I’ve sold the majority of my positions in my 2 Mexican REITs for roughly 10% gains after accounting for an appreciation of the Peso. I think these are good long-term holds, but I’m waiting for more of a crack-up before wading back into anything property related. I have a feeling that I’ll be increasingly active in busted property REITs at some point in the future. For now, they mostly look like the Ponzi MLPs that I wrote about last year. Guess it’s time to start educating myself on a few of them.

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NZME

February 26, 2017 5:23 PM


As I scour the world for opportunity, I’m usually looking at macro themes or misplaced pessimism or some other reason for an asset’s current undervaluation with an eventual catalyst. Sometimes, in that process, I simply stumble upon something that is unusually cheap. Normally I choose not to write about these, because being cheap tends to be boring—especially if there’s no added story. After some urging from friends, I intend to write about more of these situations. As always, the hard analytical work is up to you—I’m merely the messenger regarding the situation.

NZME LTD (NZM: Australia) is one of New Zealand’s largest media conglomerates, operating in print, radio and online. In a typical day, by 9am 73% of New Zealanders have engaged with NZME in some way. Every investor hates print newspapers, but New Zealand is somewhat insulated from the forces that have destroyed US papers as there just aren’t that many other options to get domestic news—especially regional news—as opposed to the tens of thousands of options in the US. As a result, while print subscriptions are declining, overall readership is increasing due to online penetration—leading to a slow decline in revenue with a more constant overall EBIT profile. Meanwhile, radio has been more constant, adjusting for some recent volatility in how sales were organized. I expect other business segments to have a negligible impact on the consolidated business. Overall, I don’t expect anything particularly momentous for this business. Results will probably range between meh and bleh, with a focus on cost cutting to offset future revenue declines—which likely leads to rather stable EBIT. In the end, advertisers in New Zealand have a rather constant annual marketing budget and there are only so many channels to push it through. Given NZME’s market penetration, it’s likely to absorb a roughly constant percentage of this revenue over time.

In summary, this is a somewhat boring cash cow which wouldn’t get my attention except for four unique facts. To start with, at Friday’s closing price of AUD $0.66, the shares change hands at roughly four times cash flow. The company reported earnings on Friday and I was pleasantly surprised at the results. I even bought a few more and I almost never pay up above my cost basis. Secondly, studies have shown that spin-offs tend to out-perform the market both for share-price performance and for operating performance in their first few years. This is because new management has greater control of resource allocation and decision making once removed from the parent. Thirdly, now that the spin-off has completed, the company has increased its dividend and the shares are now trading at a 14.4% dividend yield. 6 cents of that dividend will be paid to you in about 6 weeks, which reduces your total cost basis by almost 9%. With its high dividend yield, NZME is likely to be noticed by an increased investor base whereas the prior dividend rate didn’t scan well. Finally, NZME is in talks with Fairfax NZ over a highly accretive merger. Regulators have issued a preliminary decision to decline this merger over fears of market share dominance. I suspect that their final decision will be the same. However, if they agree to go ahead, the shares are worth a few times today’s quote. Otherwise, I don’t see why NZME with its low financial leverage and high payout ratio, cannot trade for around 10 times cash flow, or more than a double from today’s prices, while paying you a dividend while you wait.

Disclosure: Long NZM AU

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Star Bulk Redux (Time To Book Gains)

February 24, 2017 1:54 AM


I like to invest in commodity sectors that are currently losing money but at an inflection point. The companies tend to be undergoing a winnowing process with lots of bankruptcy and dilution for existing shareholders. While this may sound terrifying for some investors, this process sets up the next bull market for that sector as it consolidates players, reduces capacity and often eliminates debt. More importantly, with assets in that sector valued at a substantial discount to replacement cost, there is little likelihood of future supply entering the market. For investors, it tends to create unique opportunities to buy durable assets at a fraction of replacement cost, which offers good downside protection once you can ascertain that a bottom has indeed been reached. However, identifying a sector going through a washout is easy, the key is finding out when the sector is likely to turn around. Fortunately, this is all based on supply and demand. If you can predict the interplay of the two, you can have huge wins. Over my career, I have found some of my largest gains by looking at these sorts of opportunities.

As I’ve written about dry bulk shipping and Star Bulk Carriers (SBLK) in particular, let’s talk about that sector. Here’s some quick math (keep in mind that these are very rough numbers).

A brand new Capesize bulk carrier (known as a cape) would cost you $37 million; have a lifespan of roughly 20 years and a residual scrap value of $5 million. Therefore, its daily depreciation cost is $32 million of total lifetime depreciation/(20 years X 365 days) = $4,384 in daily depreciation cost.

The industry averages about $5,000 a day in operating costs and an additional $1,500 a day in allocated SG&A. Therefore, to simply cover your cash operating costs, you need Time Charter Equivalent rates (TCE) to at least equal $6,500 ($5,000 in operating costs + $1,500 in allocated SG&A). This is one key number. However, that would be like driving as an Uber with only enough revenue to pay for gas, with nothing left over for auto lease payments, much less profits.

The more important number is the break even on a vessel over 20 years (despite what people tell you, depreciation is a very real expense that operators and lenders look closely at). Here, you need TCE to at least equal $10,884 per day ($4,384 in daily depreciation + $5,000 in daily op-ex + $1,500 in daily allocated SG&A). This is another key number. Unless TCE is expected to be at least $10,884, no one would dare even think to buy a new cape as to do so would guarantee losses for the next 20 years.

Bulk 1

However, there’s more that goes into it. Almost all ships are financed. A bank won’t lend you money in the hope that you barely squeak through life and pay them back. They want to make sure that you can cover interest costs along with amortization of principal along with a margin of safety. Basically, the bank wants to be confident that you’ll be paid at least $13,000 over the 20-year life of the boat before they’ll cut you a loan. This is the final and most important number. Effectively, there will be no new supply until TCE hits $13,000. In effect, you have 3 key numbers, $6,500 is operating break even, $10,884 is EBITDA break even and about $13,000 is financed break even with a slight return on investment.

A commodity industry is pretty easy to analyze; the key is to figure out where supply and demand will be over the next few years and you will make a fortune. We just determined that no new supply will be ordered until TCE consistently stays above $13,000 for a long enough period of time to tempt banks to finance new construction. Simultaneously, we know that existing supply shrinks each year as older, inefficient vessels are scrapped and new costly regulations come into effect. Based on current supply and demand, we know that current rates are slightly above the operating break-even level—this means that companies can sort of cover their operating costs and interest expense, but not much else. The boats are still losing money if you factor in depreciation, but the companies can survive if they have their debt position in order. With, no new supply coming after the 2017 deliveries that were ordered a few years ago and no new ordering until charter rates stay above $13,000 for at least a year, it pretty much guarantees that there won’t be new deliveries until 2020 and probably longer. This is because you need at least $13,000 for a year to get banks comfortable, then 2 years to build a boat. As of right now, TCE isn’t $13,000 so this is all moot on the supply side. Meanwhile, older vessels are constantly getting scrapped—which likely means that net supply may actually shrink after the 2017 deliveries. You now have a potential window starting in 2018 to see charter rates recover and stay elevated for a number of years until new supply comes.

bulk 2

Over time, a combination of population growth and economic growth will lead to increased demand for dry bulk shipping—much like it has over the past few centuries. If supply is restricted, demand will eventually normalize rates.

Now, the final step is to ask what SBLK will earn at $13,000—basically the break-even level for new supply in the sector. Here’s the fun part.

During the fourth quarter of 2016, SBLK’s (TCE) was $8,202 on 67.8 average vessels and the company effectively made about 5 million in income after interest expense—but before depreciation and other non-cash costs. If you assume that TCE is $13,000, there’s $4,798 in added revenue at almost no cost. Multiply that by 72 average boats expected starting in 2018 (they are pretty much fully paid for) and you have $126 million of incremental income. That’s a big number on the roughly quarter billion market cap when I first wrote about it—heck, that was half the market cap. Add the $20 million annualized run-rate from the fourth quarter to the $126 million of incremental income and you are at $146 million. Unfortunately, you still need to subtract the $82 million in depreciation, giving you $64 million in income at $13,000 TCE. If you then put a 10 multiple on that and you have a $640 million market cap. The shares are currently at a $530 million market cap.

When I first wrote about SBLK, the downside was limited as there was no new supply coming, demand was growing with potential acceleration from Trump’s infrastructure policies and I was buying the fleet at 70 cents on the dollar. SBLK was no longer likely to go bust, so it became a waiting game with a catalyst. I am good at being patient.

Will rates overshoot to the upside and lead to windfall earnings? I don't know, but as I survey the landscape, I'm looking at higher financing costs, a global dry bulk fleet that is going to continue increasing during 2017 and a company that is probably going to do little more than break even during 2017 and I therefore feel like most of the upside has happened in three months. I intended to hold this until TCE hit $13,000 but with so much of the upside having occurred, I prefer to declare victory and move on to the next investment. We’re now pretty close to fair value for this business. The shares even trade at a premium to tangible book value for the first time in years. In summary, I’ve sold my entire position after earnings for roughly a double in three months.

simpson2

When in doubt, I like to sit in cash and wait for layups. The math I’ve used above can relate to almost any commodity business and the nature of commodities lends itself to cycles that often overshoot to the downside. In fact, quite a few of the sectors that I track are likely to bottom in the near future. Stay tuned for more opportunities.

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Mexico Is Having A Yuuuge Donald Trump Victory Sale

December 17, 2016 7:40 PM


I am writing to you from Santiago de Queretaro, Mexico, where the whole country is having a yuuuuge Donald Trump victory sale. Mexico is one of my favorite countries to visit. It combines a laid back attitude, friendly people and an outstanding culinary tradition. It also helps that it’s currently one of the cheapest places on the planet—one of many reasons that I’ve spent 5 weeks here recently (Yucatan and Central Mexico thus far).

Mexico has always been known as an affordable place with cheap beer and tacos, but the last two years have taken that dynamic to an extreme. Where else is the brand new AC Marriott $42 per night? In touristy San Miguel de Allende, we booked a 2,500 foot, 2 bedroom suite on the main square for $75 a night. Food for two with a bottle of mezcal is about $30 at the most posh of restaurants. It’s verging on silly. Between the two thirds decline in the Mexican Peso over the past two years and an over-dramatized fear of violence, the tourist economy is basically running on free. They’re just happy to see you and thankfully, my Mexican fiancé can translate my pathetic gringo Spanish as we travel around.

5 year Peso

5 Year Peso Chart. 2/3 of the value is gone in just the last 2 years.

 

If you don’t have a trip planned to Mexico, get working on it. I don’t think it will stay this cheap for long. Let’s start with the obvious question—is it dangerous? I tend to like statistics as opposed to jaundiced media reporting. The USA has a 4.5 per 100,000 homicide rate. Mexico is pushing 20, or about four times as bad. Given that I’m not terribly scared in America, four times worse doesn’t seem that bad. When you dig into the numbers, you realize that much of this crime is drug related. In fact, if you aren’t involved in narco-trafficking, the homicide rate isn’t much worse than that of the USA. Furthermore, most of the violence seems clustered in a few cities and states. I wouldn’t go to Baltimore or East St. Louis on vacation, why go to the Mexican version? Strip that all out and Mexico is on par with most of America. Unfortunately, a few dramatic incidents have cost Mexico millions of visitors a year. Eventually, perceptions will adjust to reality and the tourists will flock back—especially given how affordable it is.

I have now taken two trips to Mexico during the past 10 weeks. The whole time, I’ve kept asking myself, “How do you play this?” It’s so cheap. Despite threats of change from Trump, I know this is an overreaction. Mexico is sure to bounce back and keep growing--though, the economy may shift slightly from manufacturing towards tourism due to how cheap it is to visit.

The thing is, just because something is cheap, that doesn’t mean there’s always a “play.” There’s an old adage in finance that you don’t buy the currency of Spanish speaking countries. Pull up a 10-year chart of any of these countries and it will be obvious why that adage has weight—pull up a 50-year chart and you won’t even be able to zoom in to where we are today. The Peso has overshot recently, but it’s not an asset I want to own.

What about assets benefitting from a weakening currency? In property, if you can borrow at a reasonable rate in a depreciating currency and get paid rent in US Dollars, you’re going to make a fortune. Unfortunately, for most foreign property companies, rents are long-term and struck in depreciating local currencies. However, the hotel sector is largely immune to this. They can adjust their room rates daily. Fibra Hotel (FIHO12: Mexico) and Fibra Inn (FINN13: Mexico) have both borrowed in Mexican Pesos. Right now, the rates they’re receiving are silly. Look up some of their hotels on the internet--$20 here, $30 there. This is because there is a lag in how fast they can re-price room rates to take advantage of the decline in the Peso—especially as many of their customers are business travelers with budgets in Pesos. However, their costs are mostly fixed, the assets were built with pre-depreciated currency—they’re now worth much more in current Pesos than it cost to build them. The supply of new hotels will slow as it costs much more in current Pesos to build new ones—all the old ones have a massive competitive advantage until room rates fully reset. Meanwhile, due to Trump’s victory and the decline in the Peso, Mexican hotel REITs are being priced like something awful is about to happen—instead, a weaker Peso is a huge boon to them.

In terms of valuations, I don’t think annualizing current quarter cash flow is the correct measure to look at—as room rates in Mexican Pesos will likely rise in future quarters. That said; they trade at about ten times pro-forma AFFO and pay pro-forma Q4 dividends around 9% adjusted for stabilization of new assets. That’s very cheap for a property company with minimal leverage. With mostly fixed costs, I can model these companies to be trading for more like 6 to 8 times AFFO looking forward a year—due to a normalization of hotel rates on a fixed cost structure. A more typical measure of valuation in the hotel industry is price per room. Adjusting debt for rooms still under construction, these companies trade at enterprise values of around $30,000 to $35,000 a room, while comparable rooms cost at least twice that to construct in Mexico. This would imply that they trade for less than half of replacement cost. Interestingly, the Mexican hotel market is much more fractured than the US market. As the market consolidates, there are lots of hotels that can be purchased for 10 cap rates—even before economies of scale at a larger REIT increase the returns. Given the low leverage at both of these companies and how cheap debt is, there is likely to be continued growth as these companies take advantage of distressed players and make highly accretive acquisitions.

Fibra Inn

Fibra Inn priced in US Dollars since the IPO

Fibra Hotel

Fibra Hotel priced in US Dollars since the IPO

 

In summary, I have started small positions in each—I’m looking for further declines before I really add size. Deep down, I don’t think they’ve bottomed yet. However, they’re very cheap based on almost any metric you can use. They have growth pathways and the re-adjustment of room rates over the next few quarters should flow through the cash flow statements. Meanwhile, due to dividends, you’re paid well to wait. No one ever gets the exact bottom and Mexico is stunningly cheap, incredibly close for Americans and I expect that travel will increase as a result.

Over the next few quarters, one of two things will happen—either Trump and Mexico will reach an acceptable solution on trade where the currency recovers and average daily room rates reflect something closer to historical rental rates in Mexico when priced in US Dollars or the cheapness of the country drives more tourists and occupancy increases, while room rates are re-priced closer to previous dollar rates. Either way, I see RevPAR in US Dollar equivalents increasing dramatically over the next few quarters. In any case, I’m celebrating Trump’s victory with cheap cerveza, a cheap hotel room and two very undervalued REITs. I continue to seek out other opportunities in Mexico (stay tuned).

 

Disclosure: Long FINN13 and FIHO12

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