AIG: "Bring on Tomorrow"

I was initially attracted to AIG because of the presence of a forced seller, the U.S. Treasury.  However, now most of AIG’s short-term catalysts have come to fruition in the last month and a half, including selling 80% of their airplane leasing business (ILFC) to a Chinese consortium, the Treasury selling their remaining equity stake for $7.6 billion, and selling the remaining stake in AIA for $6.45 billion.  They’ve also rebranded their Life Insurance & Retirement and Property & Casualty Insurance businesses back to AIG (from SunAmerica and Chartis respectively) and launched a prolific advertising campaign thanking America for the bailout.  Going forward AIG represents more of a post-reorganization that needs to execute the new business model for a period of time before investors will trust it again and revalue it alongside peers.

So the investment thesis for AIG is fairly simple, it trades at roughly half of book value and expects to earn 10% ROE by 2015.  If AIG is able to grow book value at 10% over the next 5 years and the valuation gap between market value and book value converges during that time, it implies a ~26% annualized return (or over 3 times the current price).  AIG has been accelerating the book value growth through buybacks recently, however these are likely to slow in the near term as the company is switching its focus to improving the company’s interest coverage ratio, by repurchasing or retiring outstanding debt.  A simpler capital structure should reduce interest expense, improve credit ratings, and reduce the overall cost of capital, all positives.  AIG has also mentioned its intention of paying a dividend in 2013, opening it to more income based managers.

There are two large risks in my mind, the first is the overheated bond market which is the primary asset class owned by AIG.  Interest rates are low, and insurance companies are leveraged due to their float, rising interest rates could be a double edged sword.  Rising interest rates will increase earnings on the float in the long term, but also put pressure on bond prices in the short term, so AIG will have to manage its duration and continue to diversify into other assets.

Secondly there is the regulatory overhang.  AIG is expected to receive designation as a non-bank systemically important financial institution (SIFI) in 2013.  If AIG is designated as a SIFI, it will be required to carry additional capital above other insurers, hampering their profitability and balance sheet flexibility to return cash to shareholders.

Robert Benmosche, CEO of AIG, should be congratulated for the job management’s done restructuring the company since the bailout.  As the business plan is executed and AIG repairs its image with the public, the shares should overtime move closer to book value resulting in a tremendous opportunity for the patient long term investor.

Disclosure: I own shares in AIG, another way to play this story is through the warrants

Subcontinent Consumer with a Margin of Safety

I recently attended a McKinsey & Company presentation on the "Five Global Forces of Innovation" that will drive the global economy for the next several decades.  One of the five forces is what they call "the great rebalancing", essentially how the emerging economies will catch up to developed economies, especially with respect to the creation of a consumer driven middle class.  This isn't a new or groundbreaking concept, as it's been forecasted for many years, however it's a great long-term trend to keep in mind when searching for investing opportunities.

With that backdrop in mind, Retail Holdings NV ("ReHo") presents a compelling emerging market investment opportunity with a reasonable margin of safety and a potential liquidation catalyst.  Retail Holdings NV is a holding company incorporated in Curacao with no operating activities and three main assets:

1. 56.13% equity interest in Singer Asia Limited
2. Seller notes, arising from the sale of the Singer worldwide sewing business and trademark in 2004
3. Cash and cash equivalents at the holding company level with no external debt outstanding

Below is an excerpt from the 2011 Annual Report which outlines how the management thinks of the value of Retail Holdings:

"The Company's net asset value at December 21, 2011, attributable to ReHo Shareholders, was $87.6 million, equivalent to $16.51 per Share outstanding.  This essentially reflects the book value of the Company's investment in Singer Asia, the notional amount of the SVP Notes and the cash at the ReHo holding companies.  Using the $157.1 million Market Valuation for Singer Asia attributable to the ReHo shareholders, the $26.8 million notional value amount of the SVP Notes, and the $2.9 million in cash at the ReHo holding companies, the corresponding figure would be approximately $186.8 million, equivalent to $35.20 per Share.  There can be no assurance that the Company's shareholders will ever realize either the $16.51 per Share or the $35.20 per Share amounts given the substantial contingencies and uncertainties"

With that valuation framework, I'll dive a little deeper into Singer Asia and the SVP Notes.

Singer Asia Limited
Retail Holdings' main asset is a 56.13% equity stake in Singer Asia Limited.  Singer Asia Limited has ownership stakes in 5 separate publicly traded consumer durable product companies located in Bangladesh, India, Pakistan, Sri Lanka, and Thailand.  The Singer brand name is most highly associated with sewing machines, and in 2004 Retail Holdings sold the trademark and sewing machine business to SVP (fka KSIN Holdings), more on this transaction later.  Singer Asia, through its subsidiaries, now is a premier seller of consumer products (think washing machines, refrigerators, televisions) for the home, and as the emerging middle class continues to desire home conveniences of developed market consumers, Singer should be positioned capture a good amount of this long-term growth trend.  

Singer Asia's major subsidiaries are all publicly traded in their respective countries, providing easy assistance in valuing each:

The value to Singer Asia comes out to $240.55 million, with Retail Holding's 56.13% ownership of Singer Asia coming out to $135.02 million (or more than 20% above the current market capitalization alone).  In a sense the value of these underlying publicly traded companies is hidden like a Russian nested doll, with the 5 publicly traded companies partially nested within Singer Asia, and then Singer Asia partially nested with Retail Holdings. 

SVP Notes
In September 2004, Retail Holdings sold the Singer sewing business and trademark to SVP Holdings ("SVP", fka KSIN Holdings) for $65.1 million in cash, and $22.5 million of unsecured notes ("SVP Notes") which it still holds.  The question is how much are the SVP Notes currently worth?

During the 2008 bear market, SVP's operations were negatively impacted by the economic downturn resulting in an Event of Default in October 2009.  SVP cured the Event of Default in May 2010, and is now current on the notes.  As a result of the default, the interest rate on the notes increased from 10.0% to 12.0%, with minimum cash interest payments of 7% with the remaining being capitalized.  SVP has elected to pay these minimum cash interest payments since the Event of Default, and has capitalized the remainder.  These notes are clearly still distressed and unlikely to be equal to par.

In the June 30th semi-annual report, Retail Holdings disclosed they had made the following transaction with SVP:

"In June 2012, as part of an increase and extension of the financing facilities at SVP, ReHo agreed to extend the maturity of the SVP Notes from February 2014 to September 2018.  The interest rate on the SVP Notes remains at 12% with a minimum cash interest payment of 7% of the outstanding principal.  Concurrent with the refinancing, SVP made a cash payment to ReHo of USD 5,000 thousand in consideration of a reduction in the principal amount of the SVP Notes by USD 5,882 thousand, representing a 15% discount to notional value."

This transaction reduced the principal value of the remaining SVP notes to $21.598 million.  While extending the maturity hopefully gives SVP enough runway to eventually make good on the entire amount, the 15% discount is a reasonable benchmark of the current value of the SVP notes.  

Valuation
Adding together Retail Holdings three primary assets:

1. Singer Asia Limited = $135.02 million
2. SVP Notes (discounted 15%) = $18.36 million
3. Cash at the holding company level = $9.8 million (per the June 30, 2012 report)

Totaling three up yields an NAV of $163.18 million (or $30.74 per share), representing a 31% discount to the current market capitalization of $112.38 million.  

Medium-Term Liquidation 
If the discount to NAV and long term trend of the emerging middle class aren't enough, there's also the potential hard catalyst of the liquidation of the company.

"ReHo's strategy is to maximize and monetize the value of its assets, with the medium-term objective of liquidating the Company and distributing the resulting funds and any remaining assets to its shareholders."

Besides owning roughly 25% of the shares outstanding, CEO Stephan Goodman also has a special bonus in place to liquidate the company:

"ReHo has put in place a special bonus program for the Company's Chief Executive Officer which provides a cash award following the liquidation, dilution, wind-up, merger or sale of the Company, in the event that aggregate dividends and distributions to shareholders, including any final dividend or distribution, exceed a certain threshold amount."

Retail Holdings has economic trends at its back, a significant discount to NAV, and a potential value realization catalyst of a liquidation.  What's not to like?

Disclosure:  No current position, but will likely add shortly.

Howard Marks' Latest Memo

http://www.oaktreecapital.com/MemoTree/Ditto.pdf

I admire Howard Marks' ability to articulate and rationally take the market's temperature; it's always important to know about where in the cycle we are and whether investor sentiment is getting ahead of itself.  Most of his latest memo (a great read as always) is focused on the cycle in relation to the credit markets, where it's clear that we're far closer to a top than a bottom, so caution is definitely warranted for anyone adding to a fixed-income position (especially high-yield, or long term bonds).

The other aspect of Marks' memo I found incredibly insightful was his discussion on investment risk (starting on page 3, his emphasis):

Much (perhaps most) of the risk in investing comes not from the companies, institutions or securities involved.  It comes from the behavior of investors.  Back in the dark ages of investing, people connected investment safety with high-quality assets and risk with low-quality assets.  Bonds were assumed to be safer than stocks.  Stocks of leading companies were considered safer than stocks of lesser companies.  Gilt-edge or investment grade bonds were considered safe and speculative grade bonds were considered risky.  I'll never forget Moody's definition of a B-rated bond: "fails to possess the characteristics of a desirable investment."

All of these propositions were accepted at face value.  But they often failed to hold up.

• When I joined First National City Bank in the late 1960s, the bank built its investment approach around the "Nifty Fifty."  These were considered to be the fifty best and fastest growing companies in America.  Most of them turned out to be great companies... just not great investments.  In the early 1970s their p/e ratios went from 80 or 90 to 8 or 9, and investors in these top-quality companies lost roughly 90% of their money.

• Then, in 1978, I was asked to start a fund to invest in high yield bonds.  They were commonly called "junk bonds," but a few investors invested nevertheless, lured by their high interest rates.  Anyone who put $1 into the high yield index at the end of 1979 would have more than $23 today, and they were never in the red.

Let's think about that.  You can invest in the best companies in America and have a bad experience, or you can invest in the worst companies in America and have a good experience.  So the lesson is clear: it's not asset quality that determines investment risk.

The precariousness of the Nifty Fifty in 1969 - and the safety of high yield bonds in 1978 - stemmed from how they were priced.  A too-high price can make something risky, whereas a too-low price can make it safe.  Price isn't the only factor in play, of course.  Deterioration of an asset can cause a loss, as can its failure to produce profits as expected.  But, all other things being equal, the price of an asset is the principal determinant of its riskiness.

The bottom line on this simple.  No asset is so good that it can't be bid up to the point where it's overpriced and thus dangerous.  And few assets are so bad that they can't become underpriced and thus safe (not to mention potentially lucrative).

Perfectly stated, this is an important concept as an investor needs to determine when the price of a security is materially out of line with the intrinsic value of the company, many times this is due to irrational investor sentiment.

Betting on a Natural Gas Rebound

I'll start off by saying I'm not an oil & gas industry expert, probably just the opposite, so the majority of this post will be qualitative in nature, but I think any investor with a long term outlook could agree that natural gas prices must come up over time.  New fracking and horizontal drilling technologies have made previously unattainable resources accessable creating a booming supply of domestic natural gas in the United States.  The 2011-2012 mild winter didn't help the situation, it was the 4th warmest on record.  Since one of the primary uses for natural gas is heating homes in the winter, supplies remained elevated and prices dropped to below $2 per bcfe as the winter ended. 

Natural gas prices have rebounded to $3.34 per bcfe, but very few natural gas producers can turn a profit at these prices, and those that can are limiting their new investments in additional resources.  The old saying is the cure for low prices, is low prices, it causes producers to stop or slow production, and it encourages new sources of demand.  Low natural gas has increased demand in three main ways:

• Electricity utilities are switching from aging coal plants to gas as its become cheaper, cleaner, more politically agreeable
• Encouraging discussion and investment in exporting liquified natural gas to exploit the large spread between natural gas prices in the US and elsewhere in the world 
• Spurring on the natural gas as a transportation fuel trend, especially for commercial vehicles

On the supply side, producers have reduced the rig count by 50% compared to last year, it's a bit of a leading indicator so it's yet to show up in natural gas supplies.

These are two good data points to keep bookmarked to keep updated on the supply side:

• Baker Hughes Rig Count
• Weekly Natural Gas Storage Report

Last winter/spring (in hindsight too early) I started searching for a way to go long natural gas, I passed on the poorly put together yet surprisingly popular natural gas ETF UNG and stumbled on Ultra Petroleum based out of Texas.  Despite the name, Ultra is almost exclusively a producer of natural gas, and pretty much the lowest cost producer.  They operate in two main areas, the Pinedale and Jonah fields in Wyoming and then in the Marcellus Shale region of Pennsylvania (through JV partners in the Marcellus).  Below are two slides that Ultra provides on a regular basis showing their cost structure compared to peers and their breakeven points for net income and cashflow, clearly they have structured their operations in such as way where they can survive in a low price environment and thrive in a more normalized one.

 

The major concern with any smaller independent explorer is the balance sheet and their ability to meet the high capital expenditure costs.  Ultra has been proactive about improving the liquidity position as evidenced by their recent sale of mid-stream assets for $225 million.  In 2012, Ultra will spend a net $600 million on capex compared to $1.5 billion in 2011, while only modestly increasing debt.  Its clear if you listen to recent conference calls that management is not willing to spend more money than necessary in this environment and is more focused on long term profitability over short term growth in assets, just the type of management I like.

In summary, Ultra Petroleum is a great way to invest in the eventual rise in natural gas prices.  It does experience a lot of daily volatility, so have a strong stomach before jumping in and be prepared to hold it through the cycle, although it seems reasonable to assume we've seen the low in natural gas prices.

Asta Funding

As Bruce Berkowitz of Fairholme Funds puts it, "investing is all about what you give versus what you get."  One way to go about looking for value is determining when GAAP accounting rules often result in a company's assets being carried at values far less than their intrinsic value. 

Asta Funding is such a company, their main business is as debt collector on defaulted loans, not exactly a popular or sexy business model.  Asta acquires portfolios of consumer receivables for pennies on the dollar and then it goes about the collection process to recover as much of the original loan as possible.  The collection of these receivables has typically been attempted by the originator and potentially several others, these are really aged and bad debts. 

Asta Funding is a family run business by the Stern family, who control 30% of the shares outstanding.  The company's founder is Arthur Stern, who at 90 is still a company director and "Chairman Emeritus".  His son, Gary Stern, is now the President and CEO and has been in the post for close to two decades.

Asta has $106,347,000 of cash and marketable securities as of 9/30/12, with virtually zero recourse debt, versus a market capitalization of $121 million.  A little history, in March 2007, Asta made a mistake in buying an incredibly large receivables portfolio at the top of the market, called the Great Seneca portfolio, a $6.9 billion portfolio for $300 million, by far the largest acquisition they had ever done.  They paid for the portfolio with $225 million in non-recourse loans and $75 million from their credit line.  The portfolio has been significantly written down and currently sits on the books for $65.4 million versus $61.5 million in non-recourse debt.  The company's business plan is in a bit uncertain going forward as they are not making any large receivable purchases since they believe the price is too high, a market condition also mentioned by other publicly traded competitors.

The potential value in Asta comes from how they account for their consumer receivables portfolios.  When the company can no longer determine the timing of cash flows from one of their portfolios, they switch from the interest method to the cost recovery method of accounting.  Under the cost recovery method, all cash flows from the portfolio go immediately towards a reduction in the principal amount of the portfolio.  Compare this to the interest method, where a portion of the cash flows is recorded as revenue and a portion as principal reductions.  Eventually, the entire portfolio is written off under the cost recovery method even if there are still cash flowing assets remaining in the portfolio.

The cost recovery method understates the true value of the consumer receivables as it reduces revenues in the near term as the company recognizes basically no revenue until the entire portfolio has been recovered, defers taxes as a result, and then eventually creates a "zero basis" asset that has no book value but produces cash flows.

Asta experiences considerable revenue from these zero basis portfolios, $36.4 million for the fiscal year ended 9/30/2012.  The revenue received on the zero basis portfolios is surprisingly consistent, clearly showing these assets have considerable value that is not being portrayed on the company's balance sheet.  Calculating the value of the zero basis portfolios is difficult, as the company does not provide much information in any of their filings.  In order to ballpark the amount, I took an quarterly average of the revenue for the last two years, ran that revenue off at 5% per quarter for 3 years (0 revenue after 3 years), took out 40.3% for taxes, and then discounted those cash flows back at a 16% discount rate to be extra conservative.  That comes out to an NPV of $37.4 million that is being carried at zero.

Since the Great Seneca portfolio's debt is non-recourse, let's just assume that the portfolio eventually ends up being put back to BMO, the lender.  Shedding this portfolio on both the asset and liability sides would result in an overall $3,937,000 write-down.  The net effect of these two adjustments (adding the zero basis assets and removing Great Seneca) adds additional $33.4 million to the assets making Asta's current market price look even cheaper when compared to book value.

What is the company doing to close the gap between the market value and instrinist value?  Asta has been repurchasing shares, $16 million worth in the last year most of which came in one block trade with Peters MacGregor Capital Management ($9.4 million, 1 million shares).  Expect Asta to pursue similar private market transactions as the limited trading volume of their stock limits their ability to repurchase shares in the open market legally.  They also announced a fairly insignificant special dividend of $0.08 today, speeding up the 2013 dividend ahead of what is anticipated to be higher taxes on dividends next year.

Additionally, Asta has also started investing in two related businesses, personal injury settlement financing and divorce funding financing:

• Pegasus Funding, LLC
• BP Case Management, LLC

Management is potentially reaching outside of their circle of competence in these recent new businesses, however both have joint venture partners who are doing the day-to-day managing and high hurdle rates before those partners receive additional returns, the incentives should be aligned for both to be profitable.  Currently they're only a small piece of Asta, accounting for $18.6 million (listed as other investments), or 8% of assets, but these could be potential growth areas if the traditional consumer receivable portfolio business continues to be uneconomic.

Asta Funding isn't an outstanding operator or a franchise company, but it's clearly cheap and the cash position provides a large margin of safety.

Disclosure: I own shares of ASFI

Eagle - Unforced Error

I committed the dreaded "unforced error" with the Eagle Hospitality preferreds as the company announced this morning that it had failed in its attempt to sell the 13 hotel properties and had handed over the keys to the Blackstone.

Eagle Hospitality's Secured Lender Takes Ownership of 13 Hotels
Blackstone Adds to Hotel Haul with Eagle Foreclosure

In the press release Eagle states that they will use the remaining funds to wind down the operations and no distributions will be made to the preferred share holders.  Luckily this was only a small and speculative position for me, and with shares trading down 99% this morning I will likely hold my position (may need to sell for tax reasons) to see if any of the large shareholders make a stink about the outcome or there's more disclosure around what assets the company has remaining.  Lesson learned.

Quick Gramercy Update

Gramercy recently announced the closing of their two previously discussed transactions, one the Indianapolis industrial properties last week and the much larger Bank of America portfolio transaction today.

Gramercy Capital Corp. Announces the Acquisition of a $27.125 Million Industrial Portfolio

Gramercy Capital Corp. Closes the Previously Announced Acquisition of a $485 Million Portfolio in a Joint Venture with Garrison Investment Group

Both transactions closed at nearly the same terms as previously described, which speaks well for management transparency and their ability to meet expectations.  The industrial properties were purchased for cash, but management has discussed the advantage of being able to close with cash quickly and then refinancing once the dust settles, so expect to see a mortgage put on the properties shortly.

However, the closing of these properties doesn't change my valuation of the common shares as Gramercy still needs to increase assets, and thus the equity, to spread their overhead costs across a larger base.  One news item I'm looking forward to is the sale of the CDO equity and management business (hopefully before year end), if the sale brings in a material amount it would improve the outlook by freeing up additional cash for investment without issuing shares and clear most of the complexity in the balance sheet.