Ideas 16/11/2008

“And the wise ones bet heavily when the world offers them that opportunity. They bet big when they have odds. And the rest of the time they don’t. It’s just that simple” – Charlie Munger

I will not be updating this section often. Although I am a student of various types of investing, this section is for mid-long term buy and hold type investing (3-5 year periods). I also believe investors should focus on their top ideas, so this section will often include only a few companies. That being said, I have included companies from various industries and of varying sizes. All of them, in my opinion, are selling at significant discounts to intrinsic value, and offer quite a large margin of safety. Most of the companies in this section are high quality businesses with attractive growth prospects and above average returns on invested capital, that are currently selling at depressed prices. Although short term difficulties may continue, the long term normalized potential of these businesses is excellent, and their strong franchises and competitive advantage will continue to deliver value to investors over the long run (particularly companies like Adobe, Chipotle, Coach and William Sanoma). Investors can take advantage of the market’s short term view, as long as they focus on long term value.

The most compelling idea that I currently have is Ternium Steel, which is extremely undervalued in my opinion. It is not as much a ‘very high quality business”, but a decent business that is extremely cheap. Although the current price is around $6, I believe the company is worth between $35 and $40 based on various valuation methods (DCF, EPV etc.). Here is a short write up (details are left out so that investors can make up their own mind).

Company Description: Ternium Steel is one of the largest steel companies in South America, with operations in Mexico, Argentina, and Venezuela. The company was founded in 1961 and is based in Luxembourg. Ternium is managed by the Rocca family, which has a very good track record in running steel mills (example: Tenaris).

Analysis: Ternium has an enterprise value of $3,6billion (EV= market cap + net debt). In 2007, free cash flow was roughly $1,1 billion. In 2006, free cash flow was over $800 million. Earnings before interest, taxes, depreciation, and amortization (EBITDA) were roughly $1,9 billion in 2007 and $1,84 billion in 2006, implying that Ternium, the whole company, is selling at less than 2 times trailing EBITDA. This is extremely cheap when comparing Ternium to other companies in its industry, as they have multiples of 7 or higher.  The market value of the equity, which is to say the Market Cap, is actually lower than trailing EBITDA, at roughly $1.5 billion. In terms of free cash flow, the whole company is selling at about 3 times trailing FCF, and the equity is selling at just above trailing FCF. Net income in 2007 was around $1 billion, so the company’s trailing P/E is 1, with an EV/E of around 3,5. All of these indicate an extremely low valuation. And yet the company has a solid balance sheet, with large amounts of cash and manageable debt. I would think that even if, as a result of the current economic environment, the company’s bottom line were to decline by 50 to 60%, it would still represent an attractive valuation.

Why: The main reason for this undervaluation, aside from the general market panic, is Ternium’s operations in Venezuela. There are threats that Venezuelan president Hugo Chavez will nationalize SIDOR, which is 60 percent owned by Ternium and 40 percent by the Venezuelan government and SIDOR employees. When examining the annual report, however, Venezuelan operations represent 20-25% of Ternium’s income. So if the worst-case scenario plays out, Ternium’s income would only be reduced by a maximum of 25%. Still, this would mean that the company is trading at a P/E of less than 2 (1,6). However, it is also possible that the company receive a payout from the government, which would be a potential catalyst.The rest of their operations are sound, and properly managed. The main risks include a further deterioration in Latin America, but these seem more short term.

The fact that this business is relatively cyclical is another reason for undervaluation, as these sectors perform worst during recessionary periods. The most opportune time to buy, however, is during the late stages of recessions (or early recovery). Whilst I have no idea when markets will recover, it seems like the large amount of pessimism implies that we are closer to the end than the start. The market is pricing in continued difficulty for cyclicals, but over the medium term, in the event of a recovery, Ternium could recover well.

As noted by John Templeton: “You’re trying to buy a share at the lowest possible price in relation to what the corporation is worth…And there is only one reason a share goes to a bargain price: Because other people are selling. There is no other reason…To get a bargain price, you’ve got to look for where the public is most frightened and pessimistic…”. Many investors are currently extremely pessimistic about both emerging market and commodity related companies (especially steel). They are so pessimistic, in fact, that in addition to selling securities in general, they’ve been aggressively selling most emerging market steel companies indiscriminately, even sound ones. In my opinion, this has caused these securities to become undervalued, offering large margins of safety.

Other companies that I believe are undervalued include (with buy ranges):

  • AMZN: $35-$40
  • VLCM: $7-$9
  • ADBE: $19-$22
  • COH: $14-$17
  • TDC: $12-$15
  • WSM: $4.50-$6
  • INTC: $12-$14
  • CMG: $40-$45
  • GGP: $0.60-$0.75
  • MTW: $4.50-$6
  • ZINC:  $3-$4

If you would like my complete write-ups and valuations of any of the companies, please send me an email. I estimate that a portfolio made up of the companies mentioned would outperform the market quite nicely over a 2 to 3 year period. The prices included are rounded prices at which I’m interested; they should be thought of as ranges approaching prices at which I’ve bought, and am interested in buying if I have not yet done so.

Note: I am not an investment advisor, and none of my work should be considered as such. These are simply my ideas and opinions. I hold or have held positions in the aforementioned companies.

Note on Ternium DCF: Using three of my DCF models, and using a discount rate of 15% and a FCF growth rate of 5%, I achieve a NPV value range of $32-$40. A reverse DCF with a 15% discount rate shows that the current market price is implying negative 15% growth over the next 10 years, which seems far to pessimistic.


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