Sunday, February 21, 2010

Whither Junk?

The beginning of 2010 hasn’t been quite as smooth as most of 2009 was for the junk bond market. Some fear here and there, a pulled deal or two and risk spreads have widened a bit.

However, there is nothing really dramatic in this pullback. So far this year the FINRA-Bloomberg High Yield index is still up about 0.2%, but it’s 1.6% off the high achieved on Jan 11th. Compare that to some stock indices, a few of which (Spain) are down double-digits for the year and you’ll see junk has suffered only a “mild setback” in comparison.

Naturally, after a year that saw this index rise 44%, expectations might be a bit exaggerated not only from those riding the wave, but also from those anticipating a fall from those perceived “heights”

Still it’s always good to reassess one’s position. And mild or not, a setback is a loss and nobody wants to lose. So what now?

After thinking it over for about two minutes , I’ll be sticking with my junk for now thank you and here’s why:

1. The alternative is nothing. Not saying that there is no alternative, but if you’re
looking for something “safe” a 12-month FDIC insured CD at Bank of America is paying 0.80% APR. Two years: 1.11%. It’s quite ridiculous. Sure, bonds (and junk) aren’t really ‘safe”, but do you really want to give your money away to the big bad banks?

2. Money continues to flow into bonds. The Investment Company Institute tracks money flows into money market and mutual funds. During 2009, the net flow into bond funds was $374 billion dollars vs. a NEGATIVE flow of $9 billion for equity funds (which is pretty much a wash). Where is the money coming from? Money market funds (down $566 billion in 2009) and bank CDs (see point 1). Some money market funds are paying 0.01% because they can’t pay “negative” interest.

3. The boomers are getting older. The oldest boomers will be 64 this year and the youngest 46. E*Trade took a survey in 2008 (before the crash) and a majority of investors believe they are underweight in bonds and should be looking at allocating more. LINK.

4. Deleveraging continues. Despite the fact that credit is becoming easier, companies are looking to reduce debt, either by issuing equity or other means. LBO activity, which normally has the opposite effect (new issuing of debt to retire equity) has been very light.

Money flows and lack of attractive alternatives. This clip probably sums it up.

Monday, February 8, 2010

Internet Killed the Video Store

The Internet has been a major disruptive force in business ever since Al Gore invented it a couple of decades ago (Al just can’t seem to remember exactly when it was).

Of course, of the assumptions we all made about it back then, many didn’t pan out, but others did, not necessarily in the immediate, cataclysmic fashion expected, but gradually and in some cases definitively.

In any case, battles between the “new” (Internet-based) and “old” (Bricks and mortar) abound and are ongoing, some having lasted for well over a decade now.

Today on the History Channel: The war between Intenet-based mail-order movies for home viewing and the video store. Netflix vs. Blockbuster.

This one, in particular has been raging for over a decade.

Essentially the war is over. Netflix won. In their latest quarter, the company reported excellent results and has accumulated over 12 millions subscribers. Netflix put together two things that worked relatively well: the Internet and the postal service, and with low overhead, provided a model that was hard to beat. More info HERE.
Check out the stock performance:

On the other hand, Blockbuster has had to deal with a model, which is outdated, but still has its followers. They operate over 7,000 stores in 25 countries. It used to be over 9.000 but reality has forced a round of closings and more are expected. They tried to beat Netflix at its own game with a mail-based system, but faltered and apparently are now losing subscribers. The estimates out there have them at between 1 and 2 million, far behind Netflix. And they have had to contend with a second battle front, from automated “kiosks” which rent out recent release DVDs for $1 per night. (Operated by Coinstar CSTR). To fight that, Blockbuster has set up some kiosks of its own (Blockbuster Express), but it’s a $1/day rental vs. a $4.99 2-day rental (what Blockbuster offers on new releases at the store), so that’s not going to be good for margins in the short run.
Here’s an interview with the CEO. Prepared to be unimpressed. LINK.

Don’t be sad, everyone dies sometime. With Blockbuster, it’s not a matter of “if”, but “when”. A competitor, Movie Gallery, operator of over 2.000 stores under the “Hollywood Video” brand, filed for bankruptcy last week, for the SECOND time in two years. LINK.

This was supposed to be good news for Blockbuster. I’d call it mixed at best, but most likely ominous.

With all that said, here come the investment ideas, starting with the winner: Netflix.

Idea # 1: Netflix bonds. In November, Netflix issued $200 million of 8.5% unsecured bonds due in 2017 (8 years). When you can find them, they trade somewhere around 102-104%, to yield around 8% to maturity. They are callable at par in 2015. This trade looks easy. Nice yield. S&P rates the issue at BB-, which is “junk” but only “a little junky”.
One concern perhaps is that the trend towards direct downloads could grow, overtake and overwhelm Netflix. Probably. But when? These things take time. Habits do not change overnight. The horse and buggy did not disappear once the car was invented. AOL STILL has dial-up Internet subscribers, people still buy magazines and so on. The bonds look safe to me for the next 5-7 years (which is all it will take). Netflix as a business, probably hasn’t peaked yet, so let’s not worry about its demise. YET.

Idea #2 Netflix puts. Instead of the straight equity play (buying Netflix stock), I prefer a more conservative approach. The stock has traded up a bit recently and the market isn’t looking so great. So the idea is to SELL Netflix puts 6 or more months away and at strike price lower than the current price (out of the money) The stock is at 61 right now, but you can get $2 or more for a Jun 50 put or $3.50 for a Sep 50 or $5 if you want to take it to Jan 2011. What this means (I know not everyone is an expert), is that if the stock goes below $50, which is 20% less than today, you will be assigned the stock (i.e. you must buy it at $50). If the stock doesn’t go under $50, you get to keep the premium. Sure, this is not an idea with a great upside and if NFLX goes to $100, you’ll still only get your $2-$5 in premium. So be it, I’m not greedy.

Now, lets go check out the unburied corpse (Blockbuster). Without getting too “numbery”, lets point out that the company last October issued $675 mm in new SECURED 2014 bonds to pay down its credit lines. At the end of the year, the company was said to have $247 million in cash. Leading us to…

Idea #3 Blockbuster secured bonds. Now trading around 71%, those secured bonds with a 11.75% coupon, yield over 27% to maturity…IF they pay. That of course, is the question. If and “how much?” or “how long?”. These bonds have an additional advantage, if you will, that they are a “sinking fund”, paying 3.33% back in principal each quarter.

If Blockbuster manages to stay out of trouble, you would have your 71 cents back in about three years counting interest and principal. Any payments after that, be it the result of normal operation, restructuring, reorganization or bankruptcy would be profit. There would still be 60 cents worth of principal outstanding on the bonds at that point.

Before you say, “they won’t last that long”, just look how long they HAVE lasted. And there are options for companies in these downward spirals: asset sales, cost-cutting, etc. I’m often amazed how long they can go on. Sometimes they even manage to “reinvent” themselves. Heck, Businessweek pronounced Apple dead over a decade ago. LINK.

There is a lot at stake, namely the CEO pulls in over a cool million a year and the top execs all over half a mill. I wouldn’t personally give that up without a good fight.

Bringing us to…

Idea #4 for the greedy and the optimistic. No, not Blockbuster stock. That’s for the foolhardy. This one is Blockbuster UNSECURED 9% 2012 Bonds (Maturity 09/01/2012), currently trading around 22% of par for a YTM of 93%. I guess it’s obvious that the market doesn’t expect these bonds to be paid in full and on time. Being unsecured, they are behind the secured bonds in a reorg or a bankruptcy and could come out of such an event with nothing.

But then again, 22% is pretty close to nothing already. There are many possibilities, not excluding the company tendering for these bonds (say at Ford did early last year) or some sort of discounted swap. If Blockbuster can buy back or somehow write off part of its obligations at a deep discount, it can make the remaining debt more payable.
These kinds of maneuvers are what make investing in distressed assets interesting, and this is distressed for sure. Expect it to be interesting, in the Confucian sense (apparently he never said that…).

Ok, so there it is. I blogged a long blog this time. For those who didn’t bail halfway through: a thought. Think about these wars and those like them. The winners, the losers and the implications. Keep it in mind next time someone offers you some commercial real estate, a bookstore or a bank or gives you a DVD for Christmas.

Here’s a classic clip from “The Holy Grail”. Quite Appropriate.