Infrastructure: Hope Amid the Credit Crisis

Amid the current global slump, government investments in infrastructure, from a $48.1b provision for transportation in the $787b US stimulus bill to the $586b Chinese stimulus bill, present interesting investment opportunities. The recent Infrastructure Investment World Americas 2009 provided some good insights into recent trends and signals in private sector infrastructure investments.

US public pension funds have shown growing interest in such investments, with about 49 funds currently investing with a combined capacity of $38.1b and another 28 indicating preference with a combined capacity of $27.2b (source: Brian Chase’s presentation). Recently, P3 investment in the US has been focused outside of the highway sector on shorter contract P3 terms as annuity focused assets seem to be priced too high to achieve a profit.

While the OECD/ US markets have matured, the World Bank estimates that emerging markets will present a $20T investment opportunity by 2030. The emerging markets panel highlighted some of the pure play opportunities in transportation, water, electricity, and communication. India, for example, plans to increase infrastructure investments to 4.8% of GDP this year up from 3.3% in 2003. As the Indian government steers away from fully financing infrastructure to partnering with the private sector, it is introducing measures to support private sector participation for a $500b investment needed in the power and transport infrastructure over the next five years.

The clean tech and renewable energy panels showed optimism about the long term future, as United States renewable energy use is forecast to grow more than 60% during the next ten years to $60 billion in new investment within biomass, geothermal, hydroelectric, solar, and wind technologies. Conventional energy assets are also priced attractively (equities down 30-60% since early 2008) providing high cash margin producing inflation-linked income, and have a low risk profile. Natural gas midstream, MLPs, and electric transmission, especially smart grids to support intermittent renewable energy, have drawn investor interest in both acquiring assets as well as participating in debt/ equity financing. However, major investment banks have reduced their tax equity participation in renewable projects due to their increasing losses.

Since Lehman's (LEHMQ.PK) collapse, infrastructure investments have experienced capital constraints, higher funding costs, tighter financial covenants, lower leverage, wider spreads, and fewer banks in the sector having an impact on the syndication risk, which is lending to more club deals, as pointed by Geoff Haley.

With the monoline business model questioned as they were stripped of AAA ratings, the project finance bond market has plummeted;, however, the project finance loans market is still continuing to grow. Government commitments show hope for infrastructure investments, which should pick up quickly once the credit markets return to normalcy.

JAVA - put spreads for merger arb?

IBM has been rumored to make a bid for Sun Microsystems ever since the tech boom in 2000. Big blue made the right move by not overpaying for Sun, which then had a market cap of $50b. Since 2000, IBM has made a big bet on JAVA in their own products and service offerings and seen little cooperation from Sun in developing standards and plugging holes in JAVA. In ten years, JAVA platform is core to IBM’s $12b + revenues from middleware and WebSphere suite and another few billions in services revenues.

The street is focused on synergies in server business and dubbing the acquisition as a data-center consolidation move. IBM, Dell, and HP have entered multi-year partnership with Sun to distribute Sun Solaris operating systems, and Cisco is already a Sun OEM. Sun’s 10% marketshare in the server business will allow IBM to increase its share to 40% from current 30%, well ahead of HP, which has about 30% marketshare. However, an IBM acquisition would prompt Dell and HP to take a hard look at their partnership with Sun.

IBM’s control on the JAVA platform seems a more attractive reason for a potential acquisition. IBM tends to acquire mid to large software (iLog, Cognos, Informix, Rational etc.) companies, integrate their products to WebSphere, middleware and database suite and distribute through its Global Services arm. IBM’s acquisition of Java would be more in lines with that of Rational, which also had significant backing from IBM as a software design platform.

IBM’s possible offer for $6.5b or $4.5b, adjusted for Sun’s $2b net debt, makes sense now. Sun stock has slipped 22% since WSJ first reported the news. JAVA $6 April puts are priced at 60c (180% implied vol) and $5 puts at 25c. Selling the April put spreads would bring in 35c and limit the downside to 65c should the deal falls through and Sun falls below $5 level before the announcement. In the event of a deal, $6 is a reasonable floor price based on the premium that IBM has paid in past deals.

Berkshire remains AAA

On Mar 24, S&P revised its outlook on Berkshire Hathaway and its core subsidiaries to negative from stable; however, it affirmed the AAA rating on all of the BRK-A companies. S&P cited concerns about marks on the derivative contracts but maintained that it would focus on Berkshire’s operating profits, which remained strong in 2008.

Rating agencies are racing to catch up with market deterioration ever since they came under heat from investors for their AAA ratings on monolines. While rating agencies took more than six months to downgrade monolines, they decided to downgrade AIG over the weekend. In both cases, rating models had failed to price derivative contracts on ABS and other structured products, forcing agencies to consider major changes to their rating systems for structured finance vehicles.

Buffett wrote 251 odd derivative contracts, including the index contract that S&P is concerned about. However, there are some key differences in the terms of these contracts as compared to those written by other insurers: First, Berkshire has written CDS contracts on 42 individual companies, 100 companies in high-yield indices, four major stock indices, and some bond insurance – All of these bets are on marketable and liquid underlying asset classes as compared to other insurers’ bets on illiquid and complex securities such as ABS-CDOs. Second, Berkshire dictates the terms of collateral calls in the event of asset quality deterioration or rating trigger – in most cases, Berkshire posts no collateral. Third, Monolines and AIG Financial products wrote cheap contracts at the peak of credit cycle fetching 8-35 bps of premium and high leverage. Berkshire, in contrast, received an upfront $4.9b or 13% premium on the equity index contracts and does not have to worry about any loss payments until at least 2019.

Berkshire has not been immune to the credit crisis with stock down 40% from peak and CDS spreads in the 300-500bps range. While Buffett has made a small share of mistakes, he has shown his acumen as a master of capital allocation during the current crisis by scooping up 10%-12% dividends over the next 5 years from GE, GS, and Swiss Re as well as free warrants. S&P is not so much concerned about Berkshire’s operating profits and statutory capital levels at this point and would revise the outlook back to stable if Berkshire’s equity investments stabilize in the next 1-2 years.

Bank stocks - to trade or to invest?

The bank stock index, BKX, is down 75% since hitting 121.06 on 02/20/2007 and the volatility has ranged between 50-250% since the credit spreads blew up in summer of 2007. Bank stocks are behaving more like options with exceptional levels of volatility reflecting everyday market sentiment, making a difficult case for longer term investment. In the next 3-5 years, increased regulatory oversight could result in lower financial leverage, increased capital requirements and scrutiny of asset quality, and consequently lower sustainable earnings level.

The Fed's ZIRP will help some banks earn their way out of the down cycle and some other banks, such as WFC and PNC, could benefit from tax assets from acquisitions, however, any bullish bet on banks would mainly hinge on the bottoming of the credit/ housing markets and a resolution for bad assets on bank balance sheets. If the past is any predictor (the RTC resolution trust took more than five years to dispose $458.5b of assets and cost around $160b to resolve), removing toxic assets from bank balance sheets will be a torturous, long exercise.

The current crisis shares many characteristics of past crises, from the 1907 banking crisis to the 1989 S&L crisis; however, the severity of the current crisis certainly gives it the financial tsunami status. Banks’ credit ratings have seesawed from AAA in the 70s to BBB/BB in the 80s and 90s, back to some AAAs in the new millennium and now going back to BBB/BB. If we were to take clues from the past, the period of recovery for the current crisis seems to be painfully long, and can easily last between 5-10 years.

In the 90s, Citigroup (C), which hit $1.39 in October 1990, ended up as a multi bagger; however, a second act seems next to impossible with a 36% US stake and complex balance sheet to resolve. That said, there will be winners coming out of the crisis, and traditional commercial banks such as USB, FHN, and TCB seem to have better odds than their universal bank counterparts such as Citigroup. USB has one of the lowest financial leverages, generates over 50% in fee-based revenues, has adhered to conservative lending standards and their loan book is holding up better than many of their peers.

Quick recap of the crisis: The current crisis began around the bankruptcy of New Century from subprime delinquencies and spread to Structured CDOs, SIVs/ conduits and forced banks (HBC, C being the first ones) to bring SIVs on balance sheet and take massive write downs. Monoline insurers became the next victims from their CDS/ financial guarantees on super senior ABS-CDO structures. While various rate cuts, Fed interventions, and the subsequent bailout of Bear Stearns eased the market temporarily, a fresh wave of solvency crisis hit the market as the investment banking business model and AIG’s counterparty credit was called to question - Lehman’s (LEHMQ.PK) bankruptcy, AIG's bailout, and later the sale of a banking unit to Barclay’s (BCS) and Merrill’s merger with Bank of America (BAC) put pressure on the remaining investment banks to merge with deposit franchise or convert into bank holdings. The US Treasury went back and forth on RTC or the "good bank/ bad bank" structure and ended up injecting TARP preferred equity, and most recently converting preferred equity to common. The US Treasury announced plans last month to stress test banks for their capitalization needs and private public partnership; however, Wall Street has been disappointed with the lack of details on the plan so far and the consensus view is calling for action on illiquid/ hard to value assets that remain an overhang on the bank balance sheets.

For now, bank stocks may continue to be “trading stocks” for quite a few months, and it may be difficult to profit from long or short positions. Any good bank stock investments could take at least 5 years to play out. Bank stocks, or even bonds, pose significant political risk in terms of ad-hoc policy decisions and even nationalization (to many bank CEOs, nationalization means 1c dividends and loss of management control). While the Obama administration has made statements denying any intent to nationalize banks, they will run out of options if they do not start addressing the most critical issue of bad assets on banks' balance sheets.

Solar stocks come back to earth, do they belong here?

Solar stocks have been fallen anywhere between 30-90% this year as economy worsened, oil prices collapsed, and the credit crisis spread. Solar capacity has gone up by almost 50% in the last year, and the capacity is still expected to grow in good double digits next year, however, the last six months have seen spot polysilicon prices fall by almost 40%. While solar companies have developed proven capacity in the last two years, the pace of capacity expansion may face headwinds next year onwards as European countries are reducing feed-in tariff and other subsidies. US extension of ITC for next 8 years (tucked in with Emergency Economic Stabilization Act of 2008) is definitely a sigh of relief for the solar industry; however, solar stocks face some key issues in the next 12-18 months. Overall, I believe that the risk/ reward is very attractive for stocks such as Suntech (STP) as outlook for the solar industry still seems positive in the next five years.

Operating margins for solar panel makers increased to 15-20% in 2008 as companies installed capacity last year, however, the steep decline in solar panel ASPs could continue well into the next year. While declining silicon feedstock costs could help operating margins stabilize in the low teens next year, the solar demand may fall short of the 30% growth expectation in the next couple of years without new growth from outside Europe. Companies with installed capacity and scale and long-term contracts such as First Solar, and those with good conversion efficiencies such SunTech have a better shot at 30%+ growth. First Solar (FSLR) stock is pricing in the growth expectation and superior margins but STP stock is pricing almost no growth. I believe that as silicon based companies will benefit more in the next 12-18 months from the price decline and margins for non-Si based companies such as FSLR will get squeezed from resulting lower ASPs

As the credit crisis has frozen access to capital markets for new entrants, cash-rich solar companies will survive the next couple of years and remain good growth stories as they capitalize from expanding in new markets. At 8x 2009 EPS, STP is really cheap growth stock, pricing in 30%+ cuts in the panel prices next year and benefiting from growth in the US, and could easily be a 2-3 bagger in the next 12-18 months.

Bullish on Solar, Bearish on Solar Stocks

While dependence on oil, coal, and natural gas for energy source remains a harsh reality for the next thirty years, the trillion dollar question on the next viable energy source remains open. Solar energy, as a renewable power source, zero greenhouse emission, lowering cost, presents a viable and strong alternative.

However, the bulls seems to have run ahead of themselves on solar stocks. Stocks like Sun-tech Power and First Solar retreated from their 52 week high but I foresee further correction in their stock prices in the next few months. I find three reasons why these two solar stocks are overpriced: irrational growth expectations, margin compressions, and technological challenges.

Demands from Germany have fed into revenues for solar companies, FSLR (95% of sales) and STP (45% of sales) in particular. Companies such as SunPower AG and Conergy AG (CGY.DE)are the biggest customers for STP and FSLR. Both these companies have been beneficiaries of German subsidy programs, which may decline by almost 10% next year. Let us look at some numbers, with $135m in 2006 sales and $300m in YTD 2007 sales, First Solar is currently trading at 43x revenue. With $598m in 2006 sales and $386mm in YTD 2007 sales, SunTech Power is trading at 20x revenue. With all due credits as growth stocks to these companies, can they really pull off year after year 50-100% growth from Germany alone?

STP and FSLR post gross/net margins of 30/17 % and 40/4 % respectively in 2006. Such attractive gross margins have and would attract many more solar companies into the fray suppressing margins. We have to keep in mind that these companies and integrate modules, where most of the competition in solar has entered and is continuing to enter with improved technology and increased funding from venture capitals and other investors.

Conversion efficiencies of mono/multicrystalline silicon for STP ranges 14-16% while that of cadmium telluride for FSLR close to 10%. These are the lower end technologies and cost efficiencies due to long term supplier contract and non-silicon raw material choices have allowed both STP and FSLR to scale up their operations. CIGS and Polycrystalline Silicon (used by SPWR) 2-5 times conversion efficiencies.

Can FSLR and STP improve their technologies and geographic focus? Maybe. In the near future? No, because currently they are focused on selling more of what they have. US, the heavyweight that can provide geographic diversification, is slow to embracing solar for now in terms of federal regulatory support.

Carl Icahn makes the case for takeovers

You can beat all arguments to goto b-school but one, the chance to meet gazillionaires, smooze with them and possibly get a picture with him. So I feature Mr. Icahn in this blog who I met yesterday with the courtesy of Adam Dell. Adam, a venture capital and brother of Michael Dell of Dell Computers, who also teaches Business, Technology and Innovations and sits on the board of XO Communications with Carl Icahn.

Carl Icahn

Carl Icahn started his career as stock broker and became famous in the 1980s as a corporate raider through his acquisition of TWA and USX। Becoming a corporate raider demands capital and the ability to raise money and Icahn possessed both. As he talked about his first takeover attempt of an insurance company, he narrated how he had approached the CEO and the board to present his ideas for changes and found them so receptive. To his surprise, he received a call within an hour to back off or face lawsuit in all states of the union and he subsequently accepted a sweeting offer of $14m to liquidate his investments. While private equities make similar takeover bids on corporations, Mr. Icahn notes that PEs are like retailers where as he is is a wholesaler buying tons of stocks in many companies.

Carl Icahn says that Corporate America is an antiquated and corrupt system that hides behind the cover of a supportive legal system - A vicious cycle that entails corporate boards using company treasury to file lawsuits against any threats to replace the defunct system. He believes that anti-Darwinism prevails in Corporate America because the CEO would not want a strong subordinate that the board may like over him and hence people rising the corporate ladder are less smart than their superiors defying the law of survival of fittest.

Like many other corporate leaders, he believes that America is suffering from a poor education system and he is also short on American Dollar. In strong words, he announced that the virtuous cycle of foreign countries financing American consumers to buy goods and investing the proceeds in American securities and bonds thereby suppressing interest rates would eventually break. In other words, America needs to do something about its rising trade deficit.

What did I think of him? He turned out be different from the image of ferocious corporate raider to much of what he people call him now - shareholder activist. Even though we ran out of time for Q&A, he agreed to take one last question from me on Motorola because I seemed like a nice guy to him :-) He does have a good sense of humor. For now, we have one investment in common Motorola and we will see out that works out.