Monday, July 28, 2008

Crocodiles smile at Bank of America

“Crocodiles are ambush hunters, waiting for fish or land animals to come close, then rushing out to attack. As cold-blooded predators, they are lethargic, therefore survive long periods without food, and rarely need to actively go hunting.”

In this time of pain and turmoil, investors need to come out of their defensive positions and find easy prey. The J series preferred shares of Bank of America (Ticker:BAC-PJ) are that prey.

For investors, the recent banking turmoil is both a blessing and a curse. On one hand, castrophic losses have threatened the viability of the US banking system. On the other hand, for the surviving companies, there will be tremendous opportunities with reduced competition. This conclusion was presented during the recent JP Morgan Q2 conference call where analyst Mike Mayo, observing the opportunities of big banks to take advantage of weakened competition, approached JP Morgan CEO Jamie Dimon with a point blank question.

“You have been waiting your whole life for this environment,” Mayo asked, so what is holding JP Morgan back from growing through mergers with so many competitors hurt?

Bank of America is in a similar position. Despite the significant downside exposure of the Countrywide purchase, Bank of America deposits-on-hand is enough to weather any major storm. Although common shares may ebb and flow with the distress of the credit crisis, there are lower risk areas that pay premium amounts for capital. Thus, the recent opportunities to buy Bank of America preferred shares at reduced prices have been tremendous.

Any investor in this security will receive a 7.25% coupon with a par value of $25 a share for five years ending 2012. If the investor can buy the shares for less than the par value, then the yield on the shares will be higher. During the recent sell off in financial stocks in July, the shares dropped to $16 which meant a yield of 11.3% on any share purchased.

The J series preferred shares are non cumulative, meaning Bank of America can suspend paying the dividend at any time and will not incur any liabilities. For the investor, this is the downside risk of preferreds. Yet banks often issue their shares as non-cumulative because under accounting rules it allows them to use proceeds of the preferred issue toward their Tier 1 capital reserves. In most cases preferred share dividends are not cut unless common shareholder dividends are reduced to zero and/or bankruptcy occurs. In comparison, even the Bear Sterns non-cumulative preferred shares are still being paid out by JP Morgan without disruption. As of July 28, 2008, Washington Mutual (Yahoo! Ticker: WM-PR) is still paying out their preferreds shares at a 16% yield. Although I view dividend cuts to Bank of America common stock over the next two years very likely due to Countrywide exposure, credit card exposure, and real estate exposure, I do not foresee a total suspension of the dividend in any scenario.

There will only be a few times when high quality will be available at discount price. The turmoil that brought the shares down to $16 will happen again, probably sooner rather than later, and probably in relation to a bank bigger than Indymac. In most cases, the general market will be in fear of complete collapse or unknowledgeable about the opportunities that abound at this time. I recommend waiting until these preferred shares once again reach $16 / share before buying. In most cases, the general market will be in fear or unknowledgeable about the opportunities that abound at this time. Only crocodile investors who wait until the conditions are appropriate will be astute enough to identify this opportunity and enjoy the best returns.

Transparency: Position initiated on Oct 10, 2008 at $16 / share. On that day the security reached an intraday low of $15.50 / share.

Monday, July 14, 2008

One day the Smogbirds will come back

"I like to go for cinches. I like to shoot fish in a barrel. But I like to do it after the water has run out."- Warren Buffett in Oct. 2003 talking with Wharton MBA students

The Position of the Month

Stock: Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC)
Position: Long
Opening Price: Below $21.50
Expected Closing Price: Above $60

Sometimes it actually rains in Southern California, or just becomes overcast during January and February every year. During that time the depressed residents of this area enjoy nothing more than a trip to balmy climates just south of the border where there dollar goes a little further and the SPF 50 cocoa butter is plentiful off season. Grupo Aeroportuario del Pacifico S.A.B de C.V. (Ticker: PAC) is a company that welcomes the Smog Birds of Southern California to their airports on their way to the vacation resort of their choice.

GAP is one of three airport operators (the other two are Ticker: ASR and Ticker: OMAB) concessions in Mexico created in 2005 with the privatization of the airport management entity. It has 12 airports under management in the Western part of the country including Guadalajara (third biggest in Mexico), Puerto Vallerta, Los Cabos, Tijuana and smaller locations Mexicali, Hermosillo, Agaucalientes, Bajio, Morelia, La Paz, Manzanillo.

With monopoly status, the fortunes of the company are directly indicated by the number passengers passing through their airports. The 2007 annual report for the company reported passenger growth at Guadalajara over a three year period and Los Cabos over a five year period of 11% and 14% respectively. At Los Cabos, 75% of the increase consisted in higher margin international passengers.

At the end of 2007 and early 2008, the company continued to believe traffic growth will continue at previous rates unabated. As such, the company has been investing in capital expansion projects in Guadalajara, Los Cabos, Puerto Vallarta, and Tijuana airports with the intent of capturing new commercial revenues. Overall passenger growth and commercial growth were estimated at under 10% and 13-16% respectively. Customer traffic has been increasing to GAP airports due to increased international exposure of Mexico’s resort destinations and explosion of the Low Cost Carrier (LCC) industry in Mexico over the last few years. LCC traffic represented 30% of all domestic passenger traffic in Mexico at the beginning of 2007 and over 43% by the end of 2007. Given this, management entered 2008 optimistic.

But the best laid plans of mice and men go awry. The spike in oil has caused a severe pullback in airline carrier operations at GAP airports that directly effects the amount of passenger traffic.

Airport and carriers which either ceased or significantly reduced operations at this location include…

Tijuana (Aviacsa, Aeromexico, Mexicana, Avolar and Aerocalifornia)
Mexicali – (Aviacsa)
La Paz – (Avolar and Aeromexico)
Guanjuato – (Volaris, Aviacsa)

…and there are more…

The LCCs are getting directly hit from oil and, as is prudent, abandoning the smaller airports retreating to the hubs and where their cost advantages serve them well. The discontinuation of routes and operations at smaller GAP airports due to jet fuel prices make the routes unprofitable, especially for the LCCs. Even though GAP continues to see increases in traffic at its four biggest airports from this LCC consolidation trend, the net effect is overall decrease in passenger traffic overall for GAP.

This trend is reflected in the GAP stock price. From Oct 2007, GAP has moved inverse to oil. With oil now at skyrocketing to $142 / barrel and continued stress in the energy markets for the foreseeable future, a major economic downturn in the US and particularly Southern California, the major question for GAP what will be the rock bottom price of GAP as the dust settles. Even if the downturn moderates the oil price, even $80 / barrel is a cruel and unusual punishment for well funded international carriers and low margin LCCs. Additional discontinuation of routes and failures due elevated energy costs will cause significant disruptions in passenger traffic in GAP locations. For example, the American Airlines “no fly” episode cost GAP a bundle due to the fact that AA flights make up 14% of total passenger traffic at Los Cabos airport alone.

There is no better example of the future prospects of GAP than the Smog Birds of Southern California. The company also manages the second most important international route in Mexico, the Guadalajara-Los Angeles route. The broader context of a US recession aside, focused stress in the Southern California economy is bound to particularly hit GAP in terms of international passengers to resort destinations but also as So Cal residents with family ties to Mexico are impacted by decreased economic prospects.

GAP, as a monopoly, is what Warren Buffett would describe as having a “wide moat”. Strictly from a balance sheet perspective, GAP boasts assets including the airport concessions and land valued at over $1.5B. In 2007 it improved operating margins 3.4% to 45%. The company has completed capital projects that support expansion sure to come in future years. The company earned $161m last year on $320m in revenue, a cash machine. Yet due to concerns over oil the company currently holds a market cap of $1.4B. In June GAP sunk below its IPO share price of $31/share and now stands at $26/share.

I am expecting a prolonged period of pain for GAP due to oil and a US consumer led recession, and thus my recommended purchase price is below my estimated market value for the company. Despite the energy markets run up the company will still easily meet dividend commitments which are $2.01/share for ADRs which make the company always a buy, but at a particular price. I recommend accumulating GAP at $21.50/share (1.15B market cap) will provide a 9.3% yield. At this price, an investor can stay defensive long enough addresses any economic risk, oil shock risk, or carrier risk that could occur if events similar to the 1970s energy debacle are repeated. While you wait, the grittiest of Smog Birds will continue their annual migration route until their traditional margarita watering holes filled again with chattering about the 101, the 5, the 405 and the latest Hollywood gossip.§ion=REPORTES_ANUALES&tema=579&menu=INVERSIONISTAS&lang=eng

Transparency: The author bought a long position at $21/share.