Fructivore Investments

I have a certain weakness in my heart for junk bonds. Junk bonds, of course, are bonds with a sub-investment grade credit rating, and they can range from just barely on the cusp of investment grade to the point where the purchaser would have to be crazy to consider them. As Ben Graham wrote, an ordinary bond investor should never buy them, and speculators prefer a more speculative medium, and yet there are millions (now hundreds of billions or trillions) of them out there and someone has to own them.

And better still, some people can’t own them. Many institutions are limited to investment-grade holdings, so a cut in ratings means that they have to sell them. Any situation where investors refuse to buy a security for any reason other than its investment merits creates a fruitful hunting ground.

Of course, picking individual bonds is no easier than picking individual stocks, and given that the potential upside for a bond is limited to getting principal and interest while the potential upside for stock is theoretically unlimited, many people have called it less rewarding. However, the upside of bonds can be very large indeed if they sell at a discount, and the upside of stocks is effectively limited, at least for value investors, because a stock can only go up so far before it becomes too speculatively priced to consider. Even so, this limits us to bonds that are priced below par. A bond below par with a near maturity date is an advantageous situation, since the bond must be paid off at par or default, and as the time nears the uncertainty of eventual payoff lessens and such bonds creep towards par as if by magic–assuming that the company is capable of paying off the debt, typically by a new bond issuance.

Since a lot of such bonds are issued by marginal companies, it is only natural that these companies would use whatever methods they can to reduce their interest obligations. One of the most common methods is by issuing convertible bonds, whereby the bondholder can convert the bond into a given number of shares of stock that normally represents a price well above the market price. Basically, it acts like a long-lived call option.

Convertible bonds have been around for decades, and they in fact predate the options pricing models that let us figure out what they’re worth. Of course, a convertible trading at below par is probably trading at below par because the company that issued it has gone through some misfortunes since then, so the possibility of actually converting is not really much of an issue in the bonds’ valuation.

However, the accounting profession is never content unless it is making a simple thing complicated. For most classes of convertible bonds, accounting standards codification 470-20 requires them to divide the bonds between the debt on the balance sheet itself between the debt and the option component. This means that if a company borrows $300 million of convertible debt due in five years, and based on comparing interest rates, similar nonconvertible bonds would sell for $250 million, then the company would record a liability of $250 million, and every year take $10 million in additional interest costs to bring the liability back up to $300 million by the time the debt is due.

This is a useless complication that is completely inconsistent with everything most people know about accounting. It obfuscates the facts rather than makes them clear. The obligation to repay the extra $50 million doesn’t accrue in 5 years; it accrues immediately when the debt is issued (particularly since anyone familiar with options knows that it’s typically better to sell the option than exercise it, so anyone with a convertible bond that’s worth converting would probably rather write a call/buy a put and keep the bond, rather than actually convert it). The effect of this rule means that the company’s liabilities are constantly understated on the balance sheet, and that the firm has to record a noncash interest expense every year to amortize a discount that never existed in the first place.

I look upon this rule as a symptom of a disease that Marty Whitman diagnosed during the debate about expensing stock options: the assumption that financial statements should be geared only to equity holders. Stock options are an expense to equity holders because they result in dilution, but creditors don’t care if equity holders are diluted to nothing as long as they get paid. Here, too, a creditor looking at the fictitious financial statements required by 470-20 would conclude that a firm with convertible debt has much fewer liabilities and a much higher interest expense than the actual situation would suggest. Creditors other than the holders of the convertible bonds care primarily about interest coverage, and imposing a large noncash interest charge makes them feel unduly nervous. The holders of of the convertible bonds themselves couldn’t even figure out from the balance sheet what is the aggregate size of the bond issue they own. Only the equity holders would actually care about the dilution caused by converting.

As a final insult to reality, the allocation between debt and options is fixed when the bond is issued, so if the price of the company collapses the debt doesn’t automatically move closer to its full value despite the fact that conversion is highly unlikely. Without updating the figures in real time, the option premium contained in the convertible bonds tells no one reading the financial statement about the actual odds of dilution, which is what this rule was intended to accomplish.

I found out about this senseless rule while I was reading about Energy Control Devices’ bonds, which I ultimately decided against because, although the bonds are presently backed by substantial current assets, the firm itself has no operating income. Investing in such a firm basically involves placing a bet whether the firm is going to run out of money before the bonds fall due, and that sort of analysis is too reliant on foresight.

But I am considering the 2014 Western Refining (WNR) 5.75s, which sell at about 76, representing a yield to maturity of about 14% and a current yield of about 7.67%. The conversion price is around $10.80 per share, more than twice the current share price, so the possibility of conversion hardly seems to be an issue. The bonds’ credit rating is CCC+, which is the best of the bottom tier.

These convertible bonds are designated the senior bonds, but the other classes of bonds have security and guaranty provisions, so they are actually probably the junior debt. Western Refining’s total interest requirement year to date has been $61 million. Operating earnings year to date are $37 million, plus $69 million in depreciation, and $37 million in capital expenditures. Furthermore, the firm has listed $23 million in maintenance expenditures year to date. According to its financial statements, various classes of maintenance activities have a schedule of roughly 2-6 years between actions. Looking back at their history, we find that in the last five full years they have spent more than $23 million only once, and on average over that period maintenance expenditures were $16.5 million. If we assume that the company has spent an outsized amount on maintenance, and instead applied the average amount of maintenance expenditures over the years, we find that there is theoretically another $14 million in cash flows available to meet interest. This produces a theoretical operating cash flow of about $85 million to meet their interest requirements, and an interest coverage ratio of 1.25, which is consistent with a CCC or a CC rating.

Also, their working capital has expanded recently, resulting in a cash burn rate that would normally be disturbing for interest coverage issues. However, let us recall that Western Refining is an oil refinery, and the end of the last quarter coincided with the early phase of the summer driving season. Furthermore, the large amount of maintenance they did year to date has resulted in several weeks of a shutdown in production, which makes the year to date results unusually low.

Now, the fact that they are a refinery may also give investors some confidence; refining services will be in demand as long as oil is in use, and it may allow them to survive with lower interest rate coverage levels than a typical company that produces more discretionary products. However, refiners do not enjoy the advantage of a local monopoly the way utilities do, and because they are not thus insulated from competition, they are in a more precarious situation, hence the discount from par for their bonds. Western Refining also owns a chain of gas stations and a fleet of fuel distributors.

Operating income has in fact been on the decline for the last few years, which the company attributes to narrowing spreads between light and heavy crude, and the continued economic slowdown. Although the United States hasn’t built a new refinery in 30 years, Western Refining has in fact ceased operations at one of their unprofitable refineries, a move that the CEO claims will save them money. They have also raised the specter of asset impairments in their outlook, which is a noncash charge but makes the reported earnings drop dramatically for the quarter in which it happens.

Now, one of the things that recommended Bon-Ton stores to me was the possibility that the bondholders would do fine in a bankruptcy. I am not convinced that this is the case with Western Refining, as the convertible bonds are behind a number of secured and trade creditors in terms of priority. The firm has a total of about $2 billion in debt outstanding, and as I’ve calculated the firm has only $85 million in free cash flow to the firm. Doubling that to round out the year and capitalizing it at 10x creates a value of only $1.7 billion, although considering the difficulty of building new refineries in this country they may be entitled to a higher multiple. At any rate, it does not appear that they are as bankruptcy-robust as Bon-Ton, and considering the low interest rate coverage that is an issue that cannot be ignored.

Even so, the company has over $600 million available in borrowing capacity,  a large figure considering the firm has $2.8 billion in assets and the market cap of the equity is only $400 million. Furthermore, apart from a nonrecurring writeoff of goodwill and other impairments they have operated at a profit for the last five years. Accordingly, I have confidence that the interest on the convertible bonds is safe, at least as far as junk bonds go, and the likelihood of them being paid off at par is sufficient inducement to make these bonds attractive to any people interested in high yield debt.

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Investing by grocca