trademarked names across the U.S., Canada, the Caribbean, the U.K. and Ireland. Importantly, the company’s significant presence on the Gulf Coast allows Valero to export refined petroleum products worldwide and steal market share from less competitive refiners around the world. Again, with the shares down approximately 18% from recent highs and trading below 8x expected earnings, we believed that the fear and pessimism was overdone and it created a buying opportunity before the shares revert back toward our $65 FMV estimate.
Also in the energy space, we redeployed capital to beaten down Southwestern Energy when natural gas fell more than 20% during this relatively cool summer. Southwestern is the fourth largest natural gas producer in the U.S. lower 48, primarily from the Marcellus and Fayetteville basins. Despite relatively weak natural gas prices, the company grew production 18% while maintaining profitability in its most recent quarter due to the low-cost nature of the its operations. In fact, relative to the realized natural gas price of $3.65 per mcf, Southwestern has reported a 3-year average lifting cost below $1.00 per mcf and a 3-year average finding and development cost of approximately $1.50 per mcf.
In addition to the profitable E&P business, we are intrigued with the company’s midstream operations. Southwestern’s Fayetteville shale gathering system, comprised of almost 2,000 miles of gathering lines and 560,000 HP of compression equipment, and Marcellus Shale gathering system, comprised of approximately 60 miles of gathering lines, are expected to generate adjusted EBITDA of over $375 million this year. Based on the MLP structure used to surface value by other E&Ps and refiners, we believe the company could create significant incremental shareholder value by monetizing its midstream assets while awaiting a rebound in the natural gas price from seasonal lows. Our FMV estimate is $53.
CA Technologies is the largest independent provider of IT systems management software operatingacross all platforms including mainframe, physical, virtual, on and off-premises. CA’s common shares trade at a favorable valuation which compensates us for its slowing mainframe business. We’re encouraged by the company’s aggressive new product introductions and more importantly its continued focus on cost management. Our FMV estimate is in excess of $34.
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Aflac operates in 2 geographic segments, Japan and the U.S. It offers supplemental insuranceproducts such as cancer, general medical indemnity, ordinary life insurance plans, annuities in Japan and short-term disability plans in the U.S. During the quarter Aflac’s discount to our $80 FMV widened. With a leading distribution network and recognizable brand, Aflac consistently produces 20% returns on equity—quality and undervalued. These features should allow the company to once again gain favour among investors.
Mizhuo Financial Group, the second largest financial services company in Japan, trades at just9x estimated earnings per share and 85% of book value. There are no company-specific issues to warrant its undervaluation. Investor concerns are macro related; low long-term interest rates, European debt situation, and falling domestic loan-deposit spreads are chief among them. Peers Mitsubishi UFJ (which we also own) and Sumitomo Financial are also undervalued. Admittedly, we see no immediate catalyst to warrant a re-rating to book value or above. Over time, though, rising contribution from faster growing overseas markets, higher rates, and internal synergies ought to lead to a rebound in investor sentiment.
Standard Chartered is an international bank with operations in Africa, Asia, and the Middle East.Rising regulatory oversight and costs, deterioration in its loan book and a weak operating environment has soured investor sentiment. We acknowledge these issues but we also see positive signs that management is dealing with these challenges. In its first half report, the company recorded a 16% rise in loan loss provisions and a $3.4 billion rise in its highest credit risk loan category. On top of this is a depressed capital markets environment which led to a 20% decline in Financial Markets revenue (its second largest division after retail banking). Despite this, the bank’s Tier 1 equity ratio remained relatively unchanged at 10.7% (well above the required minimum) and tangible net asset value rose 3% from year end. The bank also managed to generate an adjusted return on equity of over 10%. Barring a new global recession or severe downturn in financial markets, the environment is unlikely to worsen. Standard Chartered’s shares, down 40% from their 2010 high, more than discount these issues. Our value is at least £15, or roughly 80% of adjusted book value.
Volkswagen shares have been volatile as of late after a report surfaced that it might bid for Fiat.The report has been denied by both companies and we view a merger as unlikely. The Wolfsburg-headquartered company does aim to be the number one car company in the world but it is already on course to overtake Toyota without a merger. Its namesake brand has hit rough spots in a few markets around the world but its higher-end—and higher margin—brands such as Audi, Porsche and Bentley are performing well. China remains its key market. Volkswagen continues to hold on to the top spot in China with a 14% share. Our estimate of fair value is €210.
Speaking of Fiat, we bought it too. Its lineup includes autos and light commercial vehicles under the Chrysler, Jeep, Dodge, Ram, SRT and Fiat names. It also offers accessories under the Mopar brand name. Its Fiat segment also manufactures and sells Ferrari, Maserati, Alfa Romeo and Lancia. The company’s products are distributed through its dealer networks in approximately 40 countries. Once the cloud lifts over the company’s merger with Chrysler, the stock price could migrate back toward our €9 valuation.
Las Vegas Sands, with over 85% of its revenue from faster-growing non-U.S. markets, declinedafter short-term issues recently negatively impacted Macau casino operators. With the shares down almost 20% from its March peak, we acquired them at a 25% discount to our $90 FMV.
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We’re confidently looking past near-term Macau weakness thanks to Sands’ organic growth that will outpace its market growth, its license to operate within Singapore’s gaming duopoly, the ongoing cyclical recovery in the Las Vegas market and several greenfield market opportunities.
Income Holdings
The 10-year government bond in the U.S. has fallen to around 2.4%. Concerns about an economic slowdown, no outward signs of inflation and Chinese bond buying have all likely contributed to the Treasury bond rally. We still foresee higher rates ahead. High- yield corporate bond rates have simultaneously increased and now yield about 5.6%. Our holdings have an average current annual yield (income we receive as a percent of current market value) of approximately 8%. We continue to hold a number of undervalued income positions, a few trading well below par, but with value based on asset coverage which, we believe, justifies much higher prices. And we continue to collect outsized interest income on these positions due to the depressed prices.
We look for income opportunities where interest and asset coverage are well above average (to mitigate potential risk of permanent loss) and the return relatively high (both from current income and the potential for capital gain). However, lower rates, particularly in high yield securities, have created a dearth of attractive opportunities. We will continue to explore for opportunities, both via screening and our network of contacts, and patiently await better risk/reward parameters.
We purchased the 7.75% 2021 bonds of privately held Sun Products for our taxable accounts. With a greater than 10% yield-to-maturity we are adequately compensated for the near-term competitive pressures from Tide. Sun Products offers various branded consumer products under the Sunlight dish and laundry banner, as well as Wisk, All, Surf and Snuggle.
IBI Group has reported several positives since our last update. First, the balance sheet has beenaddressed by (i) extending our convertible series from 2014 to 2019, (ii) an asset sale closing this quarter and, (iii) extending the maturity date of its revolver. Second, the operations have improved, as witnessed by the recent margin gains due to the company’s restructuring and cost containment. Additionally, IBI’s accounts receivable over 90 days declined again. We recently exchanged our 2014 notes for 2 new bonds; a 2016 7% and a 2019 7% bond. The 2016 notes equate to 20% of our original par amount while the 2019 notes represent 100% of our original par amount.
We recently purchased American Eagle Energy 11% 2019 senior secured notes. The company, a U.S.-based Bakken oil producer, raised US$175 million and the offering was priced to provide an 11.25% yield-to-maturity. Although the debt position is relatively large compared to the company’s current equity market cap of $180 million, we believe that the reported proven pre-tax net present value of reserves (discounted at 10%) of $336 million is solid and should easily cover our notes. Further, the company has successfully grown production from a negligible amount in 2012 to 2,300 boe/d today through the development of formations that are well understood after years of exceptional production results. With an average cash margin above $50 per boe, we look for cash flow to ramp significantly and leverage ratios to normalize quickly as the company continues with its development plans.
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The League Opportunity Fund notes were to mature in March 2014. However, in October 2013, the company and its many related entities filed for CCAA protection and PricewaterhouseCoopers Inc. (PWC) was court-appointed as the Monitor. We recently wrote down the carrying value of the notes from $85 to $30 based on our revised recovery estimate. Our write-down reflects updated information provided by League and PWC, including lower real estate sales estimates, higher liabilities and a liquidation plan rather than a previously considered restructuring plan, which could have provided time to improve properties for potentially higher recoveries. The timing of recovery remains uncertain though the bulk of distribution may be made within the next 12 months. We continue to work with lawyers to enforce our clients’ rights with a view to maximizing the recovery.
Of note, regarding our top income holdings: Specialty Foods, now an equity holding of a private company, held only in our taxable income accounts, is expected to return capital to us later this year (see the reference under All Cap holdings above); Advantex Marketing debentures should benefit from the company’s diversification of additional customers; JC Penney bonds have responded to improving company fundamentals and the protection provided by its liquidity and owned real estate; Retrocom REIT’s price still doesn’t reflect the underlying net asset value which is growing from optimization of its real estate portfolio; Ruby Tuesday’s operations have begun to recover while its bonds are well covered by underlying real estate; Student Transportation shares trade at a slight undervalution but could easily be the subject of a consolidation with a larger entity; Brookfield Real Estate Services continues to benefit from its steady royalties based on theincreasing number of real estate agents in its network; Dream Office REIT (formerly Dundee) has a stable and diverse stream of income; IBI Group’s debentures have seen their value bolstered by the company’s completed restructuring.
The Only Game In Town
Inflation in the U.S. rose 1.6% in June, below the Fed’s 2% target for a 26th consecutive month, and deflation is still a big concern for it and for central banks around the world. Though Fed tapering of its bond buying is set to come to an end in October, the Fed still intends to keep rates ultra-low, probably until mid-2015, and is somewhat encouraged by an improving labour market. Apart from its deflation concerns, its own balance sheet has $4.5 trillion of debt and the Federal debt at some $17 trillion dollars is equal to the U.S. GDP. Both needing to be serviced going forward with low interest rates. And the I.M.F. is also urging the Fed and other central banks to keep rates low.
With the 10-Year Treasury at a 2.4% yield, the real return is minimal. The comparable bond in Germany yields 1%, in France 1.4% and in Spain 2.4%. Imagine, the same in Spain as the U.S. Talk about the running of the bulls. These are the lowest rates in centuries.
Investors have been driven to equities because that’s where they believe they will be treated the best, with fixed income markets providing negligible nominal and real returns, especially compared to an even higher dividend paid by some large companies, and especially compared to returns on an after-tax basis, where capital gains on stocks and dividend returns get preferential treatment to interest income. Long term bonds will be much better for government and corporate borrowers than for the lenders. And even ultra-long bonds, that mature in more than 30 years, have become more prevalent. Indeed, even companies flush with cash, such as Apple and Google, are borrowing at these low rates. Some of that money used to buy back shares. Carpe diem.
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We have believed that the artificially low rates have created somewhat of a bond bubble, and that all the money printing will likely result in devaluation of money, i.e., higher inflation, ultimately leading to higher rates and to bond losses.
It may be, that with slow growth, low interest rates will be maintained longer than we have contemplated, but it is still not without the risk of unforeseen consequences, particularly of higher inflation. Remember stagflation?
Taking all into account, as we stated, we concur that equities today are likely the best, if not the only game in town. At these artificially low rates the bond game may be Russian roulette, and that should also require sanctions. Investors should be astute to buying the stock bargains that corrections present. Investor concern
