Sunday, July 29, 2007

Reverse Engineering of Warren Buffett’s December 1999 Investment in First Industrial Realty Trust

On December 3, 1999 Warren Buffett auctioned his 20 year-old wallet to benefit charity. Inside was a stock tip. A few weeks later the winner of the auction, John Morgan released the name of the company on the stock tip. It was First Industrial Realty Trust. I am analyzing the company as if it was December 3, 1999. The company was trading at $25 that day giving it a market cap of $941 million.
The Business

First Industrial Realty Trust, Inc. operates as a real estate investment trust (REIT). As of September 30, 1999, the Company owned 950 properties located in 25 states, containing approximately 65.2 million square feet. This makes First Industrial one of the largest industrial property owners in the country. As a REIT the company is not subject to federal income tax, provided it distributes 90% of its taxable income to its shareholders every year.

The Industry

The industrial reit sector has some very interesting characteristics. Industrial properties include distribution centers, warehouses, service centers, light-manufacturing facilities, research and development facilities and small office space for sales and administrative functions. Compared to other reit sectors, industrial reits maintain longer relationships with tenets because of the nature of the properties. Tenets renew leases at a rate greater then 80% and vacancy rates are very low usually around 7%, according to the book Investing in Reits by Ralph Block. The sector is much less prone to overbuilding because most properties are "built to suit" for specific customers and it takes considerably less time to construct and lease an industrial property so there is a much faster reaction time when demand weakens. Because of these factors, the ownership of industrial reits provides for consistent and high returns. Also, because industrial reits are less cyclical then other reits they are relatively recession resistant. Another advantage of industrial reits is unlike office, apartment or retail sectors, this sector has less of a need for ongoing capital expenditures to keep the building in good repair. Despite the interesting characteristics of industrial reits I doubt the reason Buffett bought was necessarily because of these characteristics. I think the reason was mostly because it was just extremely cheap.
The reit industry was doing fine in December 1999 but, share prices continued to fall. Investors ignored reits as they focused on the tech sector even though reits continued to report growing earnings. According to NAREIT, the price of all equity reits from January 1st 1998 to November 30th 1999 fell nearly 40%. Also, as stocks were trading at somewhere around 40 times earnings, reits were trading for only 8 times FFO! Currently reits are trading at 15 times FFO. Reits were yielding 9% at the time and now they yield just 4%.

The Numbers

For the year ended 1998 First Industrial had FFO of $133 million and was trading for $941 million. Giving the company a price to FFO of 7. Also, the company was trading at 88% of book value as of September 30, 1999. The company had a dividend yield of nearly 10%. Two months from now the company will report that for the year ended 1999 the company had FFO of 151 million giving the company a price to FFO of 6! After reading the 1998 annual report and the three 10Qs leading up to December 1999 I can detect no problems the company is going through. First Industrial wasn’t the only reit that Buffett invested in at the time. MGI Properties, Tanger Factory Outlet, Town and Country Trust, Baker Fentress & Co., Aegis realty, JDN Realty, PMC Capital, HRPT Properties Trust, Burnham Pacific Properties and Laser Mortgage Management all were held in Buffett’s personal portfolio around 1999. I will probably research some of these companies at some time in the future.

How it turned out

Buffett said at the 2004 Berkshire annual meeting that he sold off all his reit investments. So, I’ll assume he sold First Industrial at around the same time. He ended up doubling his money in 4 years. This proves that those with their eyes open can still find undervalued stocks in today’s market.

Thursday, July 5, 2007

My Personal Portfolio: Freightcar America Inc

The Business

The company is the leading North American manufacturer of coal-carrying rail cars. They manufactured 81% of the coal carrying rail cars delivered over the three years ended December 31, 2006 in the North American market. The company has been producing rail cars for over 100 years.

The majority of the company's business is to it's top 10 customers. These included many of the major railroad shippers (Norfolk Southern, BNSF, Canadian Pacific, CSX and Union Pacific), financing companies and the remainder are major utilities. The company maintains long range customer relationships with these companies and the chances of one of their customers moving their business to a competitor is low because of the high costs of switching manufacturers.

Coal-carrying rail cars need to be replaced about once every 25 years so most shippers buy infrequently. Combine that with the fact that the company has only about 10 customers that make up about 70% of its sales and you get a company with very choppy earnings.


The company's prospectus from 2005 has good information to help investors learn about the industry.


A Company facing a temporary obstacle

The company delivered 18,764 coal cars last year compared to 13,031 in 2005 and 7,484 in 2004. As you can see the company had a huge spike in deliveries last year and that corresponded to a huge gain in earnings. There are two reasons for the large number of deliveries last year: First, this is a very cyclical industry and it happens to be a time when the industry is doing well. Second, many of their large customers made very large purchases.

Since their customers loaded up last year, the company's deliveries will be considerably lower this year compared to last year's record. Investors dumping the shares in anticipation have caused the share price to fall below intrinsic value. At the end of the first quarter backlog of unfilled orders was at 6,006 compared to 17,794 in the comparable period last year. Earnings and car deliveries for the first quarter were about the same as last year. But, the results in the coming quarters will be much lower then last year.


Why it's cheap

The company's results will suffer for the next few quarters but they will return back to normal soon. The companies results have varied widely from year to year in the past so last year's spike is nothing new. What would make most sense is this situation is to calculate normalized earnings. Normalized earnings is an average earnings figure that helps the investor to see past Freightcar's lumpy results.

First I'll start with a normalized order rate which includes the replacement rate of current fleets and the growth factor. There are 250k coal cars in the North America. Coal cars have a useful life of about 25 years. So that yields a replacement rate of 4%. Besides replacement, there is also a growth component for the normalized order rate. Energy demand in the US is expected to grow by about 2% a year and much of this will be met by coal. So with the growth factor of 2% and the replacement rate of 4%, 6% of the total coal car fleet or 15,000 coal cars will need to be manufactured every year. Since the company will most likely maintain its 80% market share, 12,000 of those cars will be produced by the company. Also, historically 15% of the company's orders were from non coal-cars. That would add 2,000 cars to the company's yearly production. In all, the company's normalized order rate is 14,000 rail cars. This will be used to calculate normalized earnings.

The replacement rate and growth factor assumptions are very conservative and I believe that for reasons mentioned in the catalyst section below that they will be a few percentage points higher. But nonetheless the company is cheap anyway and because of my extremely basic knowledge of the industry, it's probably intelligent to err on the conservative side.

In 2005 the company delivered 13,031 cars. The margins will most likely be similar if the the company delivers 14,000 cars, so this can be the basis for calculating the company's normalized earnings. The company earned 45 million in 2005 but that includes 11 million in interest expense and all this debt has since been paid off. So 11 million will be added to this figure which yields earnings of 56 million. 150 million in cash has since been added to the balance sheet and if the cash returns 5% that would add 7.5 million to earnings. Now we're at 64 million in earnings. Since the company delivered 13 thousand cars in 2005 and not the 14 thousand figure that were looking for it's safe to assume that with this extra 1,000 cars and the added efficiencies that have been realized since 2005 Freightcar America should be easily able to make 67 million a year in normalized earnings. With a market cap of 610 million the company trades at about 9 times normalized earnings. But, there are still a few significant pluses that haven't been added in.


The Catalysts

1. Mohnish Pabrai invested in the company.

2. There will be a surge in the number of coal power plants scheduled to open beginning around the first quarter 2009. The utilities that own these plants will begin to order cars for these plants about 6-9 months before they are scheduled to open. Thus we’d expect to see a surge in new coal car shipments beginning in the second half of 2008. Here is a article in the Washington Post about this boom in plant construction. The article focuses around MidAmerican Energy's activities and David Sokol is quoted often.

The Washington Post:

"At this bend in the Missouri River, with Omaha visible in the distance, the new MidAmerican plant is the leading edge of what many people are calling the "coal rush." Due to start up this spring, it will probably be the next coal-fired generating station to come online in the United States. A dozen more are under construction, and about 40 others are likely to start up within five years -- the biggest wave of coal plant construction since the 1970s."

3. The current fleets of coal cars are at the higher end of their useful lives. The average age of the 250,000 coal cars in North America is about 17 years old and coal cars typically need to be replaced at 25 years of age. Shippers looking to replace older fleets will be a significant plus for Freightcar America. This is already the case with Norfolk Southern. They announced last year that they will replace their 33,000 coal cars over the next ten years.

4. The company has a significant cash hoard. Over 30% of their market cap is cash. The company could expand their share repurchase program, increase dividend, make an acquisition or expand their operations overseas.

5. The company is repurchasing shares. They repurchased 1/8 of the shares outstanding in the first quarter. They can repurchase a further 1/8 of shares with the current program.

6. The company returned nearly 100% on capital last year. If my calculation of normalized earnings is used the company returns about 60% on capital (after taxes are added back in). Because of this the company is on the magic formula list. The company has no debt on its balance sheet!



Note: The author has an investment in Freightcar America.

Monday, July 2, 2007

My personal portfolio: Arbitrage investment -Tribune Company

Current Price----- $29.5
Merger price------ $34
Potential return-- 15%
Annualized return- 36% assuming the transaction is completed by the end of the year

The transaction comprises of two steps first, the tender offer, which has already been completed and second, the merger in which the shares will be purchased for $34 per share. The transaction is expected to be completed by the fourth quarter. If the Merger does not close by January 1, 2008, this amount will be increased at an annualized rate of 8% from January 1, 2008 to the closing.

The preliminary proxy is out but completion of the deal rests on FCC approval and then when the definitive proxy is out, the shareholder vote. The reason for the wide spread is probably caused by the declining operating results at Tribune. It looks like Sam Zell (the acquirer) and the company are to far into the deal for them to easily walk away from the table. The merger looks fine but the risk is that if the merger is canceled the stock could fall because of the softening operating results at Tribune.

Note: The author has an investment in Tribune.

Introduction

Thank you for visiting my blog. I began investing in stocks when I was 11 years old. The funds I have invested came from a few small business I have started. My most profitable business sells used golf balls. I employed someone that regularly went to the local country club to collect golf balls out of the woods and creeks. I would purchase golf balls already cleaned from him and sell them at double the price. I bought thousands of golf balls a year so he was happy to sell them at such a large discount. I was able to make a reasonable amount of money while avoiding most of the hard work involved with finding and cleaning the golf balls. 

At about age 10 I began reading about the stock market. At that time, I had a small amount of money saved up and because I had no interest in spending it, I put it in the stock market. I invested some of the money in Wal-Mart because I was familiar with the company. The rest of the money was invested in various other companies. 

As I made more money with my golf ball business I would send the money to my brokerage account. I would look for companies to invest the money in but I grew frustrated because I had no idea what to look for to determine what companies to invest in. I went to the library to check-out books on investing but most of the books were on technical analysis and that made no sense to me. Somehow I found a book title How to Pick Stocks Like Warren Buffett by Timothy Vick. The book made sense to me. For the last three years since I read that book I've been a voracious reader of anything I can get my hands on that pertains to investing. I've read well over 50 books on investing. The stock market is the greatest game in the world. It is unbelievable how small sums of money can grow into spectacular amounts over time because of compounding. Example: $100,000 compounded at 12% a year for 50 years becomes almost $30 million. 

I'm currently studying many of the most successful investors such as Joel Greenblatt, Monish Pabrai, Warren Buffett, Charlie Munger, Edward Lampert etc. I hope that by following their methods I can do well also. Since I enjoy reading about the stock market and researching companies so much, it is my dream to someday run my own investment fund. In this blog I will discuss my portfolio and I will post about various things that have to do with the stock market.