An Inconvenient Truth

Yesterday my family watched the movie created by Al Gore, An Inconvenient Truth. The movie was highly educational and informative, providing good evidence for global warming and the increased CO2 levels that humans are continuing to spew into the atmosphere. The movie helped to highlight several megatrends:

1. Clean water will be a problem in the future as global warming dries up freshwater lakes, rivers, and mountain glaciers and we reach the limit in tapping fresh water from underneath the ground.
2. Energy demands globally are continuing to increase each year, especially in the developing world. To exacerbate the situation, the US has spews 1/3 of the world's greenhouse gases and has done very little to slow the growth in CO2.
3. Increased flooding and droughts will occur. This has been validated by the record huricane season in 2005 and also by my experience living on a farm in Maryland. Most recently on our farm we have experienced several month intervals with no precipitation at all during the fall and winter of 2006 and other months with record precipitation such as June 2006 and October 2006. The extremes seem to be a lot more common these days.
4. Trees and forests are becoming more critical to the environment to help convert the CO2 in our atmosphere to oxygen and slowing the build up of greenhouse gases in our atmosphere.

So how do we take advantage of these megatrends from a financial and investment perspective?

To be continued...

Inflation or Deflation?

On Friday, US markets closed early at 1 pm instead of 4 pm, making for what should have been a dull day. However, the day was not dull at all:

• The US dollar fell to 19 month lows today against the Euro and has fallen to near record low levels against the Pound and Chinese Yuan recently.
• In addition, the US 10-year treasury bond receded below 4.55% today down to 4.548%. The 10-year bond has not been this low since January 2006.
• Gold also climber to $637.90, within $30 of its record high
• Oil prices also climbed today above $60 per barrel, which would be expected given global growth in energy demand, except for the fact that US inventories of oil are much higher than last year at this time.

Other data that came out this week include the fact that:

• Employee wages as reported by the government are soaring, up 5% year over year. I would not have believed this statistic given the lack of raises in much of corporate America these days. However, a coworker of mine, recently left our telecom company and she is getting a signing bonus plus a big raise to take another offer.
• Discounts at retailers are extremely aggressive this season with Wal-Mart continuing to lower prices on electronics, toys, and food.

What can we make of all of this data?

Inflationary signals: Dollar falling, Commodities rising, Wages rising.

Deflationary signals: 10-year treasury bond interest rate, retailers dropping prices.

Conclusion:

1. The US economy is slowing due to slowing real estate prices, slowing car purchases, and slowing retail purchases.
2. Inflation will be muted even though commodities are increasing in demand and price worldwide. This is due to the fact that the US economy has become more of a services economy and less of a commodity based economy.
3. Those who are highly-skilled will continue to be in high demand and will be able to charge a premium for their services in today's global economy, thus continuing the paradigm shift of making some folks in the US economy very successful and wealthly while at the same time others are struggling. This conclusion is reinforced by the record bonuses to be given out on Wall Street this year.

So how do we invest successfully in an environment where the US economy is slowing, but the rich continue to do well? I will be discussing several mega-trends and themes for investing over the course of the next month.

US Economy slowing

Today, US housing construction fell to its lowest level in 6 years. Housing has been one of the major drivers of growth in the US economy over the last 5 years. The Consumer Price Index (CPI) reported yesterday also fell last month for the second straight month. Combined with oil prices diving to $55 per barrel this morning and other commodity prices in slow decline, I believe the US economy is headed into a period of very low inflation or deflation from a period of higher than average inflation. The REITs and utility averages where high-dividends rule are close to new highs which help confirm the low interest rate and inflation period that we are heading towards next year.

Hertz IPO is a bust

The Hertz Global (HTZ) IPO went off yesterday at $15 per share, lower than the anticipated $16-$18 per share planned price. People are having a harder time justifying the nose-bleed valuations for these Private Equity offerings. The stock closed yesterday at around $15.72. I anticipate that Hertz will move lower than the IPO price over the next couple of months.

Another buyout of a company I own :(

Whenever you hear the news that a company whose shares you own are being bought out and taken private, you usually jump for joy. Not in this case however.

From bizjournals.com:

Valley National Gases (AMEX:VLG - News) is a supplier of industrial, medical and specialty gases and related equipment and is based in Washington, Pa.

Caxton-Iseman Capital, the New York investment firm, is acquiring Valley National's outstanding shares for about $249 million, and assuming the company's debt for a total transaction value of about $312 million.

Under the terms of the agreement, Valley National shareholders will receive $27 in cash for each share they own, which is equal to Monday's closing price.

Valley National will continue to be based in Washington, Pa., but will now operate as a private company.

"We are investing because we believe Valley National is well positioned to expand in its existing markets and enter new geographies through strategic acquisitions and internal growth," said Caxton-Iseman managing partner Frederick Iseman.

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Valley National is being purchased without any premium provided to shareholders. To add insult to injury, as you can see by the chart, VLG has traded $5 higher in the last 6 months. In fact I actually sold half of my stake at $32 this summer because it had more than doubled from my originial purchase price. However, I never would have expected an investment firm to be able to purchase the company at only $27 per share. What a steal! The press release even admits that the company is well positioned for growth.

We can only hope that a secondary suitor comes within the next few weeks to outbid Caxton-Iseman Capital. Two years ago, I owned an oil tanker firm, Stelmar Shipping that received a buyout from another tanker firm. The final buyout price ended up being almost $10 more than the original buyout offer due to disgrunted shareholders unwilling to tender their shares to management. Unfortunately in this case, insiders own the majority of the shares, so we minority shareholders may be screwed. Oh well. I still cannot complain too much on a company who shares have doubled in the last 18 months.

Flip This Company

The Washington Post this morning had a good article on the coming IPO for Hertz Global Holdings, the largest car rental company in the world. Less than a year ago, three investment firms bought Hertz from Ford Motor Co. for $15 Billion, putting up $2.3 Billion of their own money and then loading up Hertz with more than $12 Billion in debt.

Now it gets more interesting. The three investment firms recently paid themselves a $1 Billion dividend and plan to pay themselves an additional $400 Million upon completion of a soon to be completed Initial Public Offering (IPO). After the IPO, the three firms will still control 72% of Hertz, which would be valued at $18 Billion including $12 Billion in debt.

Let’s do the math: the investment firms put down $2.3 Billion, 15.33% of the purchase price into Hertz. In less than a year, the investment firms will have paid themselves $1.4 Billion and will still control 72% of Hertz’s equity of $6 Billion equal to $4.3 Billion. In less than a year, the $2.3 Billion investment will have turned into $5.7 Billion or a return of 148%.

No wonder private equity firms are so hot and the graduates of the Wharton School MBA program are clamoring to work for private equity investment firms.

Lets ask and try and answer a few questions here:

1. Did Ford undervalue Hertz when it sold it to the 3 investment firms?

Based on the S-1 filing for the Hertz IPO, we see that earnings for Hertz were $158.6 Million is 2003, $365.7 Million in 2004, and $371.3 Million in 2005 through December 20th. If we round up to $375 Million for earnings in 2005 and divide the purchase price of $12 Billion by $375 Million, we get a Price to Earnings (P/E) ratio for Hertz in 2005 of 32. The valuation based on P/E appears to be high based on revenue growth of 8-10% per year. At first glance it certainly does not look like Ford undervalued Hertz.

2. How does the valuation of Hertz compare to its publicly traded competitor Avis Group?

Let’s take a look at Price to Sales. Price to Sales upon completion of the buyout was $12 Billion divided by $7.5 Billion in 2005 which equals 1.6. Avis Group is trading at only .11 times sales and is valued at $2 Billion versus the planned $18 Billion for Hertz.
What are we missing here?
Per the company description, Avis has approximately 6,600 car and truck locations in North America, Australia, New Zealand, Latin America, and the Caribbean.
Hertz, on the other hand, has approximately 7,600 locations in approximately 145 countries. Does having 1,000 more rental locations around the world equal 9 times the market capitalization?

Also, Avis is burdened with a substantial amount of debt just like Hertz will be after the IPO.
Hertz’s valuation after the IPO will look like a pig with lipstick in comparison to Avis.

3. What changed at Hertz to make the company worth 50% more in less than a year?

Good question. I haven’t figured out the answer yet to that given what I have read so far concerning the valuation and risks for Hertz.

4. Have the investment firms overloaded Hertz with too much debt?

Pretty close. As the S-1 states “We are highly leveraged and a substantial portion of our liquidity needs arise from debt service on indebtedness incurred in connection with the Transactions and from the funding of our costs of operations, working capital and capital expenditures.”

5. Does a firm that is burdened with a ton of debt justify such a high valuation?

The market values stocks per supply and demand in the marketplace. I am interested to find out who is buying shares of the Hertz IPO in order to justify the valuation.

To be continued...