Value Investing

Marty Whitman Q3 Letter: Detroit Ch. 9 to be ‘Very, Very Expensive’

Marty Whitman’s Third Avenue letter to shareholders for Q3

Dear Fellow Shareholders:

Marty Whitman Q3 Letter: Detroit Ch. 9 to be 'Very, Very Expensive'

There was an interesting article in the July 22, 2013 issue of Fortune entitled “The Party Could be Over for Stocks.” The most interesting part of the article is that it describes precisely what Third Avenue Management does not do when it comes to analyzing equity securities.The Fortune analysis seems irrelevant for Third Avenue shareholders.

The gravamen of the article is that the Federal Reserve Board might reduce its $85 billion of monthly bond purchases and end the program entirely by mid-2014. As part of the change in the Fed, the government agency will no longer deploy extraordinary measures that have driven down interest rates over the last five years. Low interest rates resulted in a bull market for equities because the yields on bonds that compete for investors’ money stayed so unenticingly low. This bull market was never justifiable based on so-called fundamentals—dividend yields and earnings potential.Also, lower interest rates mean that earnings are not likely to increase. Further, Price/Earnings ratios are currently quite high—the S&P 500 P/E ratio stands at 18.4x for the latest twelve months period and 23.6x for the 10-year average of inflation adjusted earnings.

The article ignores completely three fundamentals that are crucial in any Third Avenue analysis of a common stock— first the creditworthiness of the company issuing the equity; second, the ability of the issuer to grow net asset value (“NAV”) (or its surrogate book value) over the intermediate to longer term; and, three, the price of the common stock relative to NAV.

While anecdotal, it seems likely that U.S. corporations whose common stocks are publicly traded are more creditworthy today than has been the case since the 1950s and the 1960s. In part this is an outgrowth of the era of easy money from2007 to 2013.

NAVs have continually increased. At July 31, 2013, the book value of the companies making up the Dow Jones Industrial Index was 60.7% higher than it had been at December 31, 2007; and the comparable increase for the S&P 500 was 28.4%.

At July 31, 2013, the Dow Jones Industrial Index was selling at 3.0x book value and the S&P 500 was selling at 2.5x book value. In contrast, most securities in the various Third Avenue portfolios are selling at anywhere from 0.6x NAV to 1.0x NAV. Since the companies in Third Avenue’s portfolios enjoy Returns on Equity (“ROE”) comparable to the companies in the S&P500,the P/E ratios for the Third Avenue companies are much below those of the S&P 500.Third Avenue’s P/E ratios are estimated at around 10x, rather than the 18.4x for the S&P 500. Further the Third Avenue companies on average are probably more credit-worthy than the S&P 500 companies, i.e., they enjoy stronger balance sheets. Also,for the Third Avenue companies, I am confident that most of the issuers will increase NAV in most future reporting periods(as has been the case in the past) albeit it may be that such NAV increases will be smaller than had been the case from 2007 to 2013.

At Third Avenue we know how hard it is to predict the future, and we are especially skeptical of anyone’s ability (including our own) to make successful macroeconomic predictions. Assuming that conditions are bad economically, but without social unrest and physical violence in the streets, many Third Avenue portfolio companies will be in a position to make super attractive acquisitions, as was the case after the 2008 Financial Crisis. Such Third Avenue portfolio companies include Brookfield Asset Management, Cheung Kong Holdings, Exor, Investor A/B, Pargesa and Wheelock & Co. One final comment about the Fortune article. It seems doubtful that there is a close relationship between bond yields and dividend returns on common stocks. The correlation certainly exists where the investors are primarily interested in cash return. As far as I can tell, most common stock investors are interested primarily in total return,with cash return being distinctly secondary, and most bond investors do not own common stocks because they need contractually guaranteed interest payments, (e.g., banks and insurance companies).

MOTOR CITY BLUES

While Third Avenue is not directly involved, our readers might be interested in my take on the Chapter 9 bankruptcy of Detroit.

In the USA, outside of a court proceeding (usually a bankruptcy case), no one can force a creditor to give up a right to a money payment for principal,interest or premium unless that individual creditor consents. Therefore, a voluntary program in Detroit could never have worked— too many hold-outs.Chapter 9wasinevitable.

Creditors in Chapter 11 and Chapter 9 cases, can be coerced into accepting a reorganization with either the requisite votes of the impaired classes of creditors, or a cram down (a reorganization workout ordered by the bankruptcy court without the requisite vote of impaired classes of claimants and parties of interest). True liquidation does not seem to be an option for Detroit. For practical purposes,Chapter 9 is just like Chapter 11, except that the period of exclusivity for the debtor to propose a Plan of Reorganization (“POR”) lasts forever, and unlike corporate Chapter 11, as part of any reorganization it may be impossible to give ownership interests to pre-petition creditors to satisfy part or all of their claims. Also in Chapter 9, no trustees are likely to be appointed. After all, unlike corporations,Detroit and Michigan are sovereign entities. The goal of Chapter 11 and Chapter 9 is to make the debtor feasible (i.e., creditworthy) within the context of maximizing present values (“PVs”) for creditors and also comporting with a rule of absolute priority where no creditors of a class are treated to different values than other members of the class.There are two broad classes of credits in Detroit—Secured and Unsecured. Secured credits ought to include certain municipal bonds which become senior up to the value of the collateral. Pension, retirement and healthcare liabilities seem to be unsecured. This will be vigorously argued for a long time by very able lawyers and investment bankers, all of whom will be paid by Detroit.

To accomplish a successful reorganization, you follow what you would do for a Leveraged Buy Out (“LBO”)—first determine forecasted cash flows, realizations from asset sales and the debtor’s dynamics. Then, apply an appropriate capitalization to the above. In an LBO, you leverage up. In a Chapter 9, you deleverage as part of a POR.

To make Detroit feasible on an operational level seems a Herculean, possibly impossible, task. Maybe regional authorities like Port Authority of New York, Metropolitan Transportation Authority, or Bay Area Rapid Transit can be important contributors to a feasible reorganization. No matter the difficulties, reorganization has to take place somehow. Perhaps Detroit and the surrounding region can attract new, productive investments. Detroit seems to enjoy a relatively efficient infrastructure (e.g., a great highway system), lots of land and, probably, sharply reduced labor costs.

For Detroit to obtain a feasible capitalization, provided operations can be stabilized, there are only a few things that can be done to compromise some $18 billion of obligations:

• Reduce principal

• Reduce interest rates and/or cash interest payments

• Alter covenants

• Extend maturities

• Provide credit enhancements

I would bet that as part of a POR the State of Michigan, the private sector and/or Federal agencies will have to provide credit enhancements to Detroit via either dedicating tax revenues to Detroit and/or guarantying obligations. There is ample precedent for this. New York State,through the Municipal Assistance Corporation (“MAC”), credit enhanced New York City obligations in the 1970s.Credit enhancements,incidentally,could create a lot of investment opportunities for Third Avenue.

Detroit’s Chapter 9 will take a long time and be very, very expensive. Detroit, under Chapter 9, will have to pick up all administrative expenses for almost every participant in the reorganization (say, professionals hired by the Committee of Retirees) i.e., lawyers, investment bankers, accountants, actuaries, etc. Detroit will pay them on a priority basis in cash with perhaps minor holdbacks on a pay as you go basis. I can almost guarantee that Administrative costs for Detroit will be at least $500,000,000 and might well be in excess of $1,000,000,000.

I shall write you again after the end of the 2013 fiscal year for the Third Avenue Funds on October 31st.

Sincerely yours,

Martin J.Whitman

Chairman of the Board

Marty Whitman’s Third Avenue on specific stocks

Susser Holdings

Susser Holdings (“Susser”) (SUSS) traces its roots back to 1938 when Sam and Minna Susser opened two service stations in Corpus Christi, Texas. Seventy five years later, the company is the second-largest non-refining convenience store operator and motor fuel distributer in the state of Texas and one of the largest company-operated convenience store chains in the U.S. (operating under the Stripes® banner) with operations in Oklahoma, New Mexico and Louisiana as well. We view Susser as a compelling long-term investment opportunity for a host of reasons:

• Growth: Susser has a strong track record of growing organically and via acquisitions under the leadership of CEO Sam L. Susser (grandson of Susser’s founder).

Since Sam joined the company in 1988, Susser has grown from five stores and revenues of less than $10 million to more than 500 stores and revenues of more than $5 billion,completing 13 significant acquisitions along the way (not including Susser’s wholesale distribution operation which also supplies fuel to more than500third-party locations). Impressively, Susser has grown same-store sales every year since then as well, and generally delivers among the strongest per-store statistics seen within the industry. With more than 90% of its stores located in Texas,the state’s booming economy and strong demographic trends (young, rapidly-growing population, low unemployment, ranked number one in job growth) should continue driving strong growth for Susser for years to come. In addition, Susser should continue to take market share through 1) the accelerating buildout of higher-volume and more profitable big-box stores (two to three times the cash flow of its smaller legacy stores); 2) price-disciplined acquisitions (the convenience store industry remains highly fragmented, with numerous mom-and-pop operators); 3)entrance into under-penetrated Texas markets; and 4) increased offering of more profitable diesel fuel.

Management: Based on conversations with Susser’s management, other industry executives and industry analysts, it has become abundantly evident to us that Susser’s management team, while relatively young, is highly competent, innovative and laser-focused on creating long-term value for shareholders.Importantly, management has earned a reputation for being best-in class with regard to utilizing sophisticated technology systems for data gathering and analysis to improve all areas of its operations (e.g. fuel pricing, inventory management, labor utilization, and shrinkage)—a significant competitive advantage in our view. We are also encouraged that insiders own close to twenty percent of the company,creating a strong alignment of management’s interests with those of outside long term shareholders.

• Laredo Taco Company: In the early 2000s Susser created a proprietary food service concept named Laredo Taco Company (“LTC”) that serves freshly made tacos and Mexican food in a growing number of its convenience stores. LTC is arguably Susser’s strongest competitive advantage today as it generates 1) incremental customer traffic, 2) much higher margins than fuel sales, and 3) the sale of other high margin merchandise with most transactions.

• Susser Petroleum Partners: In September 2012, Susser spun off its Susser Petroleum Partners (“SPP”) wholesale fuel business into a Master Limited Partnership (MLP) structure that provides fuel to Susser, as well as to third parties. While this structure creates a degree of “analytical noise” as it relates to the company’s reported GAAP financials, it creates a more appropriately valued “currency” for SPP that it can use for growth and acquisitions while it effectively lowers Susser’s cost of capital. Moreover, in addition to being the controlling general partner and majority limited partner of the MLP, Susser also holds a hidden asset of sorts in the form of Incentive Distribution Rights (IDRs) which effectively entitle Susser to an increasing portion of the MLP’s distributions as it grows. While the distributions will likely be modest over the near term, SPP has attractive growth opportunities over the long-term through organic growth, acquisitions, and Susser stores being “dropped down” into the MLP via sale-leaseback transactions. The business model also provides a significant competitive advantage to Susser as it is able to take advantage of SPP’s combined retail and whole sale fuel purchasing volume to obtain attractive pricing and terms.

• Financial position: Since coming public in 2006, the strength of Susser’s balance sheet has steadily improved. In the wake of the SPP initial public offering and resulting proceeds, Susser has been able to refinance its debt at attractive rates and ultimately reduce its net debt to about one times EBITDA3 (down from about four times EBITDA in 2007).

• Valuation: Despite being recognized as among the highest-quality businesses in the convenience store industry, we were able to invest in Susser’s retail operations at an implied valuation4 of less than six times trailing EBITDA, which represents a glaring discount not only to broader industry valuations but also to private market transaction values.In addition to its high-quality operations, we would argue that Susser deserves a premium valuation for its ownership of Laredo Taco Company in light of the brand’s strength within Texas and the relatively high valuations ascribed to similar public “quick service restaurant” concepts.

CST

Fund Management added a second, related holding in CST Common (CST). With nearly two thousand locations throughout the U.S. and Canada (operating primarily under the Corner Store ® banner), CST Brands is the second-largest independent retailer of motor fuels and convenience merchandise in all of North America. CST came onto our radar coincident with its recent spin-off (May 1, 2013) from Valero Energy Corporation, one of the world’s largest refining companies. As a result of only recently becoming an independent entity, the company’s shares appeared to be temporarily “orphaned,” with little sell-side sponsorship, for example, and no readily accessible financial data. CST enjoys a steady, cash-generative business in part because of its relatively broad geographic exposure, with operations spread across nine states in the U.S. (predominantly in the Southwest) and Canada (predominantly Quebec and Ontario). Encouragingly, CST’s single largest geographic exposure is the state of Texas (at about a third of CST’s store base), giving CST the most exposure to the state’s fast-growing economy (based on store count) of all independent convenience store operators. New incentives for management and an ability to allocate capital accordingly will likely help to accelerate corporate growth since former parent Valero appeared to view CST as simply an outlet for motor fuel distribution rather than supporting the potential within its store base.
In addition to growth in the store base,CST also appears particularly well-positioned to improve its margins over the coming years. We see margin improvement coming from multiple sources, including 1) new larger-format stores that are more profitable than legacy stores, 2) increased focus on food merchandise sales which are much more profitable than fuel and cigarette sales and 3) improved technology systems to better manage inventory and costs (currently upgrading its SAP system). In addition to these initiatives, we expect CST management to make acquisitions in an industry that remains fragmented and characterized by smaller, less efficient operators. The Fund’s current cost basis equates to an undemanding (in our view) eight percent free cash flow yield.

TW

Our current investment in Taylor Wimpey (LSE:TW), the U.K. homebuilder, illustrates several additional ways that accounting figures can be misleading. We first bought shares of Taylor Wimpey in April 2011, in the midst of a severe U.K. housing depression. The company had been producing enormous accounting losses, as its land holdings were being written down to values reflective of the economic depression in which the auditors were assessing the values. Meanwhile, the company also found itself selling houses at depressed prices built on land that had been purchased in years prior at much higher costs. On the face of it, the accounting statements were ugly. While Taylor Wimpey was forced to make downward accounting adjustments to its asset base, it owned the same amount of property within its land bank both before and after the write downs.The accounting losses at that time did not, in our minds, reflect the long-term economic reality of the business. As we look at Taylor Wimpey’s financial statements today, the stock having nearly tripled from our cost, the company is producing record profit margins.The large profit margins are, in part,enabled by current high house prices in the U.K., but additionally by the fact the Taylor Wimpey’s costs are artificially reduced by virtue of its land having been written down during the real estate depression. In our minds, neither during the industry depression nor in recent record-breaking quarters have the company’s financial statements been an accurate representation of reality. In both cases, material analytical adjustments are required to reconcile the financial statements to the real world and the truth is probably somewhere between the two extremes.

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