Wednesday, December 07, 2011

Interesting opportunity in AMR 7.5% 2016 Senior Secured Notes

American Airlines (NYSE:AMR) recently filed for Chapter 11, following a standoff with its pilots union over wage negotiations. American is the only one of its peer group (aside from Southwest-LUV) to have maintained its expensive legacy liability structure, in the form of expensive union contracts, onerous work-rules, and large unfunded pension (>$5Bln underfunded).

Currently, most items on the McDonald's Value Menu are more expensive than AMR stock and its unsecured debt obligations have fallen precipitously to $.20. The secured bonds for AMR trade mixed, with 1st-lien secured (newer aircraft) bonds trading near 8% or par, 2nd-lien bonds near 10%, and older-aircraft deals in the mid-50s to yield 15-20%. American is expected to reject a number of leases on its 85 older MD-80 planes (45% of leased portfolio, which should result in significant cost-savings and additional  unsecured claims. The estimates of unsecured claims range from $13-25Bln and is difficult to estimate, given significant issues like lease rejections on facilities, planes, engines and the potential for American to dispose of pensions to the PBGC. 

While the newer secured plane deals are probably money-good, they offer unappetizing returns near 8% that do not meaningfully compensate for the potential headline risk and volatility that can occur in a bankruptcy. The unsecured debt at twenty cents offers significant upside in the bull case (200-300% return possibility), but there are massive uncertainties with respect to how aggressive AMR management will be on the union contracts, pensions, etc. If the restructuring and pension/cost-cutting is significant, it will incur sizeable unsecured claims that dilute bondholder recovery. In the bear-case, it could result in loss of principal and/or negligible return over the expected 18-months that the bankruptcy case may take to fully resolve.

My preferred security is the 7.50% Sr Secured Notes Due 2016, currently trading at $74 (near 17% YTM). The security package on these bonds is exceedingly attractive, as it is comprised of American Airlines profitable international routes to China, Japan, and London. The full security package also includes highly sought-after slots and gates in Heathrow and Japan, both of which would likely have strong demand from third-party buyers. My understanding of the indenture is that if American chooses not to affirm this bond and continue payments, then bondholders can force the trustee to seize each of these slots, gates, and routes which would effectively destroy American's international business (including their decade-plus relationship with British Airways, as their gateway partner into Europe). There are numerous reasons American would not commit such folly:

1) The most recent appraised value of the collateral package (gates, slots, route authorizations) was approximately $1.526Bln as of 09/30/2011. This exceeds the outstanding amount of 1st Lien Notes by a factor of 1.5x, which suggests strong over-collateralization and that American would be wiping out potential equity value that exists above the lien.

2) American's international business is currently profitable, their domestic US business is not. Disrupting the only profitable part of its operations would cripple the business and also damage international traffic that is being fed into its US network

3) Future access to capital will be needed- American just priced this deal in March 2011, at a time when its ratings were below investment-grade and potential restructuring seemed possible within the next few years. This deal was structured to protect investors during any likely restructuring, by providing them with collateral that was previously a part of its bank credit facility until 2009

4) Access to routes in Asia and London are highly sought-after, with London/Japan being the most slot-constrainged airports in the world. American would have a tough time ever regaining a foothold in international markets and jeopardize billions in enterprise value if it attempted to impair bondholders of this issue. This seems like a silly thing to do if the only upside was to squeeze bondholders out of a couple hundred million dollars. It would be much easier to squeeze costs by eliminating workers, pensions, excess facilities, and older planes. That is where the real fat seems to be.

5) American has left foreign trade creditors and suppliers out of its US bankruptcy filings. They have not cancelled flights or suspended frequent flyer miles, along with indicating an intent to remain a going concern. American is entering bankruptcy at a time of strong industry "cooperation" on flight capacity and pricing, along with having a cash hoard of $4Bln that ensures adequate liquidity during its restructuring. Based on this, they appear to have given every intent on maintaining current hub-strategy and international partner alliances (particularly British Airways alliance). As such, it would negate the possibility of American walking away from their leases and their note obligations.

What could go wrong?- Although there seems to be strong likelihood of AMR surviving and affirming payment of the 7.50% Notes, there is the risk that a significant economic contraction (i.e- European economic meltdown) significant decreases travel demand and the value of the underlying routes. If such an event caused American Airlines to liquidate prior to 2016, the value of the collateral may be negligible because the leases and authorizations would likely have no bidders and zero recovery value.  We believe an AMR liquidiation is unlikely and that this scenario is remote, but worth considering given the severity of the recovery value.

Summary- Buy the 7.50% 2016 notes, believe bonds will trade up to par (35% near term upside) once the Notes are affirmed by the bankruptcy judge (in my estimation, 99% probability given the Trustee report that has been published).

Tuesday, November 22, 2011

Socialists Probably Hate Sports....

Currently, many people are protesting in the streets against the phantom "1%" of elite earners that consume the majority of wealth in our country. Fashioning their agenda loosely on socialist principles, it seems strange that many of these people have no problem with how sports are run in our country. In many professional sports, a top-tier athlete (Michael Jordan, Lebron James) might earn 20x what starting players make on the same team.

Similar unfairness exists in the way the contests are decided. If a basketball team loses a close contest by the score of 100-98, it is simply recorded in binary fashion as Win=0, Loss=1. The losing team scored nearly the same amount as the winning team, yet receives 100% of the assigned losses. A "fair system" would reward the winning team with a .51-.49 record The distribution of win-loss records is completely skewed and fails to reward the loser for their skill and effort. Our "unfair" sports system has become accepted methodology that we have no problem with as a society (at amateur or professional level).

People hate to lose, especially when it feels like they are losing all the time.  At the same time, it is crucial to realize that people accept the concept of "winner-take-all" competitions, provided that they have a fair chance at being that winner (who "takes all"). This basic idea of fair-play is twisted by those that attempt to relate fair-playing fields with a "fair" distribution of outcomes. Just because people want fair competition does mean that they want a fair and balanced outcome.

Take football for example, the sport demands a basic set of rules that are enforced by neutral officials. Basic rules outlining what areas are "out of bounds", a touchdown, or a penalty are what defines the competition.

While fans demand an objective set of playing rules that apply to all teams, this does not mean they desire equal outcomes. For instance, Chicago Bears fan wants their team to win 100% of games against the Green Bay Packers, by any method allowed in the rules. If there are subjective calls by the officials, they want to see 100% of them decided in favor of Chicago. If there are unfortunate injuries, the Chicago supporter wants to see 100% of them occur to Green Bay players. There is nothing "fair and balanced" about this distribution of outcomes desired by the Chicago fan, even though the process itself is fair.

Similarly, most sport fans suffer no moral dilemna or quandary when their favorite team has a disproportionate talent advantage versus its peers. Such examples include the NBA (Chicago Bulls had Michael Jordan/Pippen/Rodman on roster), NFL (Dallas Cowboys had Troy Aikman/Emmitt Smith/Michael Irvin), or MLB (New York Yankees with highly-paid all-star roster). While fans of these teams enjoy watching them win multiple championships, they admire them for succeeding on objective playing fields with objective rules. The Bulls had to dribble up-and-down the court like every other NBA team, much the same as the Cowboys had to drive a full 100-yard field like every other NFL team. Very few people would celebrate their team's win if it came about from a referee-bribe or clearly rigged match.

So what is the point of this? Fair rules and processes do not always lead to fair outcomes. When they do lead to "fair outcomes", such outcomes are not always deemed desirable, regardless of how random they are.  At the end of the day, they don't split championship trophies into 1/2s or 1/4ths.

Friday, November 11, 2011

Danger from the Pursuit of Fairness...

Academics often confuse fair-play with fair outcomes.An example of confusing fair-play with fair outcomes is economist Noreena Hertz, who wrote an editorial in the FT titled, "Women Still get a raw deal in business and finance". In her article, she states,

"That banks could be discriminating against women customers should not come as a complete shock. In the US, banks deemed single women poor credit risks until the 1968 Fair Housing Act. Until the Equal Credit Opportunity Act of 1974, women had to have a co-signor to become mortgage borrowers and before the 1975 Sex Discrimination Act in the UK, banks were legally able to reject a woman’s loan request because they were not seen as a good risk. In the absence of clear legislation and a commitment to enforce it, discrimination historically has been the default"
The thesis of the article is that banks unfairly discriminate against women and refuse them loans. Her examples ignore historical context entirely. For example, Ms. Hertz cites US/UK bank refusal to lend to single women in the 1960’s. But women were worse credit risks in the 1960’s, due primarily to the active discrimination against them in the workplace and in schools. The lack of maternal-leave and sexual discrimination laws hampered women’s ability to achieve sustainable employment that fairly compensated them for their skills. This societal discrimination impaired women’s creditworthiness by limiting their capacity to repay a loan. (What would Ms. Hertz say to the hypothetical Saudi banker that refuses a woman a business loan, due to the fact that she is not allowed to drive herself to work every day? Is the credit officer supposed to ignore the barriers that Saudi laws and society have imposed upon her? While unfair to women, it is difficult to blame the banker for not making the loan)

Without a doubt, sex discrimination is unfair and has impeded the progress of many capable women. However, it is equally unfair to blame the bank lender for the fault of wider societal bias. Banks are supposed to be in the business of making loans that will be repaid, not social engineering to fix broader societal bias (look no further than subprime CRA lending in the US, it hasn’t worked out so well for us). If Ms. Hertz really wants bank lenders to open their checkbook, she would do better to plead the case of how profitable/safe such lending can be, rather than demanding fairness (which only comes from broader political and social changes).

Summary- While people generally want a society that is fair and provides ample opportunity to succeed, but fairness will never come by expecting other human beings to act against their best interest. The good intentions of such socialistic ideas create a conflict, as lenders are forced to fund marginal-ideas that crowd out more innovative and interesting business ideas. As a result, the playing field is skewed towards whichever special-interest group has the ear of the country's leader, rather than who has the best idea.


Wednesday, November 02, 2011

Eric Falkenstein on Chance, Effort, and Ability

Excellent post at Falkenblog on the critical linkage between Chance, Effort, and Ability-
"Success is the result of randomness, effort, and ability. If you omit one of these, you will be miserable. A lot of growing up is about finding what you like that you are good at, and usually you like things you are relatively good at. Then practice that skill until you become excellent at it. The rest you can't really worry about even though that too is important, especially in explaining things like why certain people are really rich, which is often being in the right place at the right time. This should make us content because it's all we can control."
Falkenstein's post was a rebuttal of the argument that most wealth attainment is the result of simple luck and randomness (versus skill, hard work, ingenuity). The key point is that success is most-often the result of a combination of elements: Chance, Effort, and Ability. On the other side of the spectrum, many institutional investors fail to understand this concept as well. Funds chase recent performance trends and managers promoting themselves with buzzwords like "portable alpha". More often than not, their returns are due to financial leverage or assuming risks their investors are not aware of. The investment process is the only thing that investors truly control, not the outcome!

Be extremely wary when someone promises a certain outcome with respect to markets or macro-events that are beyond their control. Hide your wallet, voting proxy, etc. and run the other way. An easy example might be a Presidential candidate promising the following:
     1) I will reduce the price of gasoline to $2/gallon, 
     2) I will reduce unemployment, 
     3) I will ensure that mothers do not have their homes foreclosed upon
     4) I will get government out of the way and let the free market work

This short list of contradictory promises/statements were all made by same politician (Rep. Bachmann). Take Promise #1: While $2 gasoline sounds like a great outcome, there is no substantive process for how it would be accomplished. Based on current technology, the most logical path to $2 gasoline would be a combination of crippling deflation, higher unemployment (lower demand for gas), or outright government intervention (price controls or banning automobiles). Each of these processes to achieve the desired outcome ($2/gallon gas) are clearly bad and have very negative side effects. This is why the process is so much more important than focusing strictly on outcomes! 

Even when you implement a "good process" does not guarantee a good outcome. Some of this is explained concisely in a chart created by Michael Mauboussin for his book "Think Twice",


The lesson to take away is:  implement a good process that you can consistently repeat and employ in both good and badtimes, along with not getting a big head over your success (it may be partly due to luck!) For investments, that means avoid being over-leveraged and concentrated in positions that you are not a control investor in.  This allows you to take advantage of future opportunities that do not exist and cannot be foreseen. In the words of Louis Pasteur, "Chance favors the prepared mind"...and portfolio.

Sunday, October 30, 2011

Jeff Matthews Is Making it Up... on Apple

I like Jeff Matthews, he is an interesting guy and I followed him for awhile.

However, his recent post on Apple appears to be very poorly thought out and ignores fairly obvious facts. In the article "Apple: For What its Worth", Mr. Matthews suggests Apple is having a retail traffic problem based on his following observation:
"For example, from the December 2009 to the June 2010 quarter, retail visits rose from 51 million to 61 million.  This year, visits from December 2010 to June 2011 did not rise at all—from 76 million to 74 million."

Mr. Matthews willfully ignores the different release dates for key Apple products between 2010 and 2011, hopelessly undermining any possible point he was trying to make. Apple is driven by a few key products, with current best-sellers being the Ipad 2 and Iphone 4S (released Oct 4, 2011). In fact, the Iphone 4S has had one of the strongest levels of demand (at-launch-date) of any product Apple has ever released.

Apple products are big events that draw huge crows for opening-day release. The previous Iphone 4 version was released June 28, 2010, thus fell within the bounds of Q2 2010. The recent release did not occur until Q4 2011, so why would Jeff Matthews believe Apple investors should focus on Q1/Q2 foot traffic in Apple stores?  Perhaps Jeff Matthews believes investors visit Apple Stores simply to enjoy the aura and vibe of older Apple products (which they likely already own at home?)

The only relevant comparison is demand at-launch for relevant product releases. Jeff Matthews may be shocked to learn that consumers only wait in lines at Apple Stores for new Apple products, not old ones. Hence the difference in foot traffic. Ironically, Mr. Matthews post was reblogged by fairly prominent people from Josh Brown, to Barry Ritholtz and Herb Greenberg without making this fairly obvious observation.

A rare shortcoming for Mr. Matthews, but pretty silly one all the same.


Beating Analyst Estimates Means Very Little (Apparently)

Beating Analyst Estimates Means Very Little (Apparently)
An interesting chart was posted showing the number of S&P 500 companies "beating" analyst estimates.

As seen below, the number of "beats" has trended significantly higher over the past 20 years. So much so, that even in third-quarter of 2008 when the US market experienced one of the largest one-quarter shocks since the Great Depression, nearly 58% of companies still managed to "beat expectations".

Ironically, as more and more companies have beaten expectations, actual equity market performance has been abysmal (for more than a decade). Perhaps we can go back to the good old days of the mid 1990's when fewer companies met analyst estimates and their stocks performed strongly anyway.  

Conclusion- While various studies have shown that changes in earnings expectations generate abnormal returns, the charts below suggest there is little value in trying to predict whether companies will beat analyst expectations (since most of them do "beat" consistently and the long-term market impact is negligible.

20-year S&P Chart

Monday, October 24, 2011

Netflix's "coming to jesus" moment arrives...

My last blogpost noted that Netflix was in a bubble (at $165/share) in September 2010. In after-hours trade, the stock is down to $85/share, for a nearly 50% haircut.

As you might recall, the main reason for citing Netflix as being in a bubble was based only partly on valuation and the rising costs to procure content. The real catalyst was the utter hubris displayed by Netflix CEO Reed Hastings who deferred to his core subscriber base as "self absorbed" and ill-informed of anything going on the world. This hubris was evident in Netflix attempting to raise prices 60% and split their services, as if they were selling an inelastic product (i.e- milk, gasoline, etc).

I will defer to my prior post on Netflix, but needless to say the massive increases in content-acquisition cost have not filtered into the amortization on the income statement (Nor have they gotten Starz to agree to content deal yet).

Summary- I would say this, at an $87 price, Netflix is trading at a $5bln Market cap (<2x sales and 12x EBITDA). The company has a base of subscribers that have greater monetization and loyalty than any of the stupid coupon/groupon/deal sites that seem to be tickling investment banker's fancy. As such, Netflix has greater "network value" that is inherently more stable then a flash-in-pan like Groupon (who is wholly reliant upon retailers offering 50% discounts to Groupon for free on an ongoing basis).

 IF Groupon managed to IPO at a ridiculous valuation of $10Bln, it would be an interesting long/short to buy Netflix/short Groupon. Otherwise, have no position (no current short position in stock, currently short Netflix streaming following service cancellation)

Thursday, September 23, 2010

How To Spot A Bubble? (So you think you're a contrarian? Part Deux)

In re-hashing my for-profit education stance, I came across another element of being a contrarian: spotting bubbles

Case in point: Netflix- $165/share. Yes, the stock has risen 800% Year-over-year. Yes, I am a subscriber and love the service ( I would cancel cable before I would cancel netflix). The reason I am comfortable calling Netflix a bubble is based upon the level of hubris displayed by Netflix CEO Reed Hastings in a recent interview. Here is an excerpt from the interview with "The Hollywood Reporter",

"THR: American services when they enter the Canadian market typically charge the locals more than they charge stateside. Why the discount for Canadians?

Hastings: We want to provide an incredible value for Canadians, and it's the lowest price we have anywhere in the world for unlimited screenings. And anyone can try it for free for a month. It's pretty addictive.

THR: Are you concerned that American Netflix subscribers will look north and ask for the same discount Canadians get at $7.99?

Hastings: How much has it been your experience that Americans follow what happens in the world? It's something we'll monitor, but Americans are somewhat self-absorbed.

THR: How will you will measure success for Netflix Canada?

Hastings: I'm certain we'll succeed, so it's kind of a matter of degree. We're not quantifying that in terms of subscriber numbers or profitability. What we're focused on is getting out there. We've got to get out on all of the devices, get the word out, and we need to be such a good service that people not only stay with us but rave to their friends about it. "

I'm not so appalled by the fact that he views Americans as ignorant and self-absorbed, as the fact that he does not measure success in terms of subscribers and profitability. It should be no-big-secret that Netflix was cashflow negative under its traditional 3-out-at-a-time plan for $19 (due to high postage and DVD replacement costs) and only turned free-cashflow positive due to its streaming business (subscriber growth exploded under its $9, one-at-a-time, unlimited streaming plan- due largely to lower shipping and dvd replacement costs).

Netflix's existing streaming agreements were priced opportunistically as content-owners failed to envision the subscriber growth that Netflix would generate from being able to stream through newer DVD players/TVs/gaming systems. Unfortunately, those contracts do not run forever and Netflix will find itself in the same difficult position as cable companies in a few years (forced to pay much higher rates for streaming). The difference is, Netflix posesses no major barrier-to-entry or competitive advantage like the cable companies do.....

I am not short NFLX yet, but at $8.3Bln market capitalization (4.4x sales/16x Ebitda) I firmly believe that NFLX shareholders will have a "coming-to-Jesus" moment at some point over the next two years.

COCO a Go-Go....

Since my recommendation to buy COCO (Corinthian Colleges) and WAPO (Washington Post) on 08/16/2010, both stocks have increased in value by a substantial amount (+25%, vs +5% for the S&P 500). At its peak today, COCO was up more than 36% over the past month.

As it turns out, the Education Secretary Arne Duncan announced they were "keeping their options open" and that final DOE regulations could be delayed. This should lead to significantly more upside in both COCO and WAPO.

Previously, I laid out a number of potential problems with the bear-case, which included skepticism that: 1)Racially-divisive gainful-employment rules go into effect on schedule without any changes 2) Belief that upcoming Congressional elections might create uncertainty about final rule adoption (Republicans want to extend oversight of not-for-profits, not just for-profits) 3)Current valuations imply that COCO/WAPO shutter their entire programs overnight, giving zero credit to ancillary programs (Heald College) or foreign programs (17% of assets in Canada)

Essentially, if you priced a business at liquidation value (i.e- 2-3 earnings and below tangible book value then suddenly decide suddenly that the business will live a little bit longer... you will have made a huge mistake selling-out and materially underpriced the value of the franchise. There is uncertainty in all human endeavors and perhaps an above-average level of uncertainty in federal funding, but with 30% of the company's shares shorted and the forward business value priced near zero.... I believe the pessimists are over-confident in their analysis to the point of arrogance.

Remain long COCO ($6.50) and WAPO ($375), in spite of my disgust of for-profit education stocks.