Here you can find the Pershing Square Q1 and Q2 letter to investors. The Q3 letter highlights the possible consolidation of the retail book industry, which increases the probability that BGP is included in that potential merger activity. The Q1 letter, talks about the $20 bid from Simon Properties and why the GGP board wisely turned it down. Enjoy the reading.
Archive for August, 2010
Return on capital vs return of capital
A high return on capital should outweigh a low return of capital in the case of Domtar Corp (UFS) at current prices. In 2006, Domtar completed the acquisition of the Weyerhaeuser Fine Paper Business, which gave the company the #1 market share in North America for uncoated free sheet paper; this was a very important transaction for the company (and industry) as it turned the industry into an oligopoly. Domtar is currently operating 10 paper mills with uncoated free sheet capacity of about 3.9mm tons and has the #1 market share in North America with about a 35% share; International Paper is #2 with about 25% share and Boise is #3 with about 10% share.
Business:
Domtar has three segments: (i.) Paper, which includes the uncoated free sheet manufacturing and pulp businesses, (ii.) Paper Merchant, which runs warehouses and distributes both Domtar paper and that of competitors, and (iii.) Wood, which the company has an agreement to sell and should close in the coming months. The Wood business has been a money loser (even from an EBITDA perspective) over the past few years and the company will realize about $95mm in net cash proceeds from the sale. The Paper Merchant business is not a meaningful cash flow perspective, but is noteworthy because sales of Domtar paper are much higher through this channel than with other distributors.
Positives/Negatives:
The biggest negative for the business overall is the structural industry decline of units of uncoated free sheet paper, which is due to increased use of computers, email, ipad, etc. The management team pegs the decline in units at about 4% per annum, which we think is a reasonable estimate. On the other hand, the consolidation of the industry has provided pricing power to the remaining players in the industry. In fact, in one of the most difficult business environments in recent history (2008-2009) prices actually went up, which is shocking to anyone following the industry over time.
Pulp:
While the pure uncoated free sheet business has remained steady at about $200mm of EBITDA per quarter, the pulp business has been wildly volatile. The pulp business lost about $75mm per quarter in the first half of 2009 and was positive by about $30mm in the 3/10Q. The decline was primarily due to one of the sharpest declines in pricing ever in that industry. The company has about 1.7mm ADMT per year of pulp in excess of the company’s internal requirements, which causes the swings in profitability.
Balance Sheet:
Net debt peaked in 2007 at about $2.4 billion following the Weyerhaeuser transaction and has steadily declined to about $1.3 billion at the end of the 3/10Q. This can partially be attributed to strong cash flow from operations over that time frame, but also partially due to black liquor tax credits that the company received as a nice gift from the government. I won’t get into the mechanics of the credit (Google it), but it basically provided the company with about $500mm in cash, of which the company will receive $350mm in the 6/10Q. (Also noteworthy, the company is getting about $75mm from the Canadian government in tax credits to use to upgrade facilities.) The company is using this cash initially to pay down debt; following a recently completed debt tender, the company should have ~$950mm of debt that is all senior notes (no bank debt) with most of the maturities after 2013.
Cash Flow:
Current sell-side estimates for EBITDA for 2010 and 2011 are about $1.0 billion and $900mm respectively. We think the normalized over the next few years is about $775mm less $175mm main capex gets you to our normalized pretax unleveraged cash flow of about $600mm. If you assume interest expense is $100mm and taxes of $125, the real free cash flow is about $375mm or about $8.75/share. What are they going to do with all this cash if their debt is fixed for several years (and at their target leverage)? Return it to shareholders. The company reinstated its’ dividend at $1.00/share annually and has a $150mm authorization to buy back stock, which we think will be utilized in the near future (and probably increased).
Valuation:
Less than 6x after-tax normalized free cash flow in a relatively unleveraged company even for a paper company with declining units is cheap.
An intro to valuation
It’s in the best interest of every investor to know the exact value of their investments. However, more often than not, business value cannot be precisely determined. Any attempt to precisely value an enterprise, will yield values that are precisely inaccurate because business value changes over time, fluctuating along numerous variables such as macroeconomic and microeconomic factors. This is the beauty of valuation. It’s more an art than a science. How can you precisely value a business that, unlike debt instruments, may not have a constant stream of cash flows? Thus, the value of a business is never a single number, but a range of values where the highest estimate is sometimes twice as much as the lowest one. For example, we all experienced the difficulties or impossibility to value an enterprise such as General Growth Properties. I remember that at the beginning of the bankruptcy process, valuation ranged from $5 per shares to more than $20. That’s where opportunities arise. If securities could be valued precisely, there would be few differences in opinion, market prices would fluctuate less frequently, and trading would diminish significantly, making our job useless. Discrepancies over the value of a business result from differences among the assumptions used, especially discount rates, projected cash flows, differences among the valuation methods used. I consider three different valuation methods that can be used to value en enterprise.
Absolute value
When futures cash flows are reasonably predictable and an appropriate discount rate can be chosen, the absolute value represents the most reliable source of information. However, cash flows are usually uncertain and the choice of the appropriate discount rate is usually an area of debate, hence we have to be careful when we use this valuation method. In the context of absolute valuation, cash flow, which comprises of dividends, free cash flow or residual income, is discounted at the required rate of return to find the PV of such cash flows.
Dividends
Generally, using dividends as cash flows is most suitable when the company is dividend paying, the board of directors has established a dividend policy that bears an understandable and consistent relationship with profitability and the investor takes a non-controlling ownership, because shareholders do not have control over the dividend policy.
Free cash flow
Valuation using free cash flow to the firm (FCFF) or to equity (FCFE) is most suitable when a company is dividend-paying but dividends significantly fall short or exceed FCFE, the company doesn’t pay dividends at all and the investor takes the ownership prospective. However, applying the free cash flow approach posts problems in some cases. Some companies have intense capital demands and, as a result, have negative expected free cash flows far into the future. A profitable enterprise that is expanding may have a negative free cash flow indefinitely because of the level of capital expenditures. The present value of a series of negative cash flows is a negative number, therefore the use of a free cash flow model entails a long forecast horizon to capture the point at which expected free cash flow turns positive. The uncertainty associated with such forecasts may be considerable.
Residual value
Conceptually, residual income is the book value per share plus the present value of expected future earnings reduced by the equity charge. Because the record of residual income can always be calculated, a residual income model can be used for both dividend-paying and non-dividend-paying companies, and for companies with negative expected free cash flow with reasonable forecast horizon. However, the application of the residual income model requires a detailed knowledge of accrual accounting. In some cases, the degree of distortion and the quality of accounting disclosure can be such that the application of the residual income model is error-prone.
Relative value
A valuation method relies on price multiples that sophisticated and prudent investors have recently paid to purchase similar businesses. For example, multiplying a benchmark value of the price-to-earnings (P/E) by an estimate of a company’s EPS provides a quick estimate of the value of a company’s stock. The concept behind price multiples is that a stock’s price cannot be valued in isolation (absolute value). Rather, it needs to be evaluated in relation to what it buys in terms of earnings, net assets, or some other measure of value. The economic rationale behind the method of comparables is the “Law of one price”, which is the economic principle that two identical assets should sell at the same price. But what can constitute the benchmark? Generally, it’s the mean/median multiple of the company’s peer group within a certain industry, or the mean/median multiple of the company’s whole industry sector or the company’s own past multiples. However, this valuation method is not without shortcomings. The method of comparables argues that a firm with multiples below the benchmark is undervalued, and with multiples above the benchmark is overvalued. In this case, the fundamental of the stock have to be similar to the fundamental of the benchmark before we make any direct comparison and draw conclusions whether the stock is overvalued or undervalued. Let’s suppose that, after hours of research, you determine that the P/E of the stock you are trying to value is less than the benchmark. There are at least three possible explanations for this:
- The stock is undervalued
- The stock is properly valued, but it has a lower expected growth rate than the benchmark, which leads to a lower P/E
- The stock is properly valued, but it has a higher expected return (higher risk or required rate of return) than then benchmark, which leads to a lower P/E.
In order to conclude that the stock is truly undervalued, we have to make sure that the stock is comparable to the benchmark, it should have similar expected growth and similar risk/return.
Liquidation value
The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment opportunity. The assets of a company are generally worth more as a part of a going concern than in liquidation, hence liquidation value is generally a worst-case scenario assessment. When no crisis is at hand, liquidation proceeds are maximized through an orderly winding up of a business. Cash is worth one hundred cents on the dollar. Investment securities are valued at market prices, less any transaction cost. Accounts receivable are appraised at close to their face amount. The value of inventories is not easily determined and it depends on whether or not the inventories consist of finished goods, work in progress, or raw materials, and whether or not there is the risk of technological obsolescence. The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flow and their next best use. Emulating Benjamin Graham, the approximation of the liquidation value of a company can be calculated as “net-net working capital”, which is net working capital minus all long term liabilities. As long as working capital is not overstated and operations are not rapidly consuming cash, if a company could liquidate its assets, extinguish all liabilities and still distribute proceeds in excess of the market price to investors, it represents an attractive opportunity.