Author Archives: Alpha Vulture

Some comments on Aswath Damodaran’s Aramco post

I suspect that many readers of this blog also follow the blog of Aswath Damodaran, and if they don’t, I would recommend doing so. Damodaran is a Professor of Finance at the Stern School of Business and he often posts how he would approach valuing high-profile stocks such as Tesla or Uber. It’s very unlikely I would ever be interested in investing one of those companies, but his valuation methodology is pretty solid and his posts are educational. I think having a good grasp on the fundamentals of valuing a company is very important, even when most of the time you revert to simple back of the napkin valuations using a P/E multiple (which I do).

However, I disagree strongly with his approach in his latest post about how to incorporate truncation risk in the valuation of Aramco. To quickly recap Damodaran point of view, a DCF valuation is only suitable for going concerns because you assume cash flows are continuing long-term and potentially indefinitely. Because of that you can’t properly model survival risk where a company might cease to exist after a certain point in time. In the case of Amerco it could be a possible regime change at some point in time to fundamentally change the value of the business going forward. But it’s also very relevant in startups that have a high probability of not making it past the first few years. His suggested solution is to value the company as a going concern in one scenario, value it with a regime change in a second scenario, put some probabilities on the two scenarios and call it a day.

Aramco equity valuation model incorporating regime change risk, source: Aswath Damodaran

I think there are two problems with his post:

  1. This approach doesn’t work well because it doesn’t fit reality
  2. A DCF is perfectly capable of incorporating truncation risk

The reason that this methodology is flawed is because it doesn’t incorporate the timing of the potential event. It matters a whole lot if the regime change is in the next year, or if it happens in 30 years time. So what does a 20% probability mean? Is that a 20% probability of regime change happening this year? the next 5 years? the next 50 years? And because that question isn’t answered, you also can’t really do a equity valuation in the regime change scenario. What he is doing I think is just taking the going concern equity valuation, and reducing it by 50% in the regime change scenario to account for higher taxes and royalties. That implicitly assumes that the regime change will happen on day one, which is of course highly unlikely and unrealistic.

A better model would be to assume that there is a small probability of a regime change every single year. That sounds complicated, but luckily, that’s exactly what we can model in a DCF by increasing the discount rate. If you would for example assume a 1% probability that there is a regime change in a given year you can simply increase your discount rate by 1%. It’s that easy! A one percent chance for 10 years in a row would imply a probability of regime change of 9.56% during that period and 39.5% during a 50 year period.

Note that by increasing the discount rate by one percent in case of a regime change we are assuming that the residual value is zero. If you think there is a 1% probability with 50% residual value we should increase the discount rate by just 0.5%. And a second small note, if you want to do things mathematically correct, you have to multiply probabilities, not simply add them!

If you want you can also easily change the model to customize probabilities of failure for each time period. Perhaps you have the view that there is in the next five years a higher chance of regime change, followed by a period of lower probabilities. But it’s probably more useful when thinking about a startup. The probability of failure is presumably very high in the first few years while lower in subsequent year.

Let’s imagine a project that will costs 10 million to start and 10 million more at the end of the first two years, and will produce 100 million at the end of year 3 and 4. In the first two years there is a 25% probability of failure. We could (and should!) model that as following:

Hypothetical cash flow model with high risk of failure in first two years

Note that the discount rate is calculated by taking: 1 - (1-"equity risk") * (1 - "truncation risk") and the NPV factor is the factor of the previous year multiplied by (1 - "discount rate") of the current year. That way you carry a risk of total failure that you introduced in the early years forward for the calculations of the net present value of later years.

The great thing about this model is that it matches actual reality. If you have a failure in the first year you don’t have to put more cash in the project, that’s why the net present value of the cash outlays at the end of year one and two are severely discounted. And of course, the same is true about the payoff in year 3 and 4 because there is a high probability that the project will never get to that point. If you would want to model this using Damodaran’s approach you would be in big trouble, because one single failure scenario can’t easily account for the fact that failure can occur at different times, and that the impact on the net present value depends on the timing.

Concluding remarks

Let me know in the comments if you found this post useful, otherwise I will be back to posting the occasional merger with a contingent value right ;). And of course, perhaps you want to point out that I’m completely wrong. It’s totally possible that I don’t know things better than someone who is a professor of Finance.

Disclosure

No intention to ever initiate a position in Aramco

A last minute merger arbitrage in Celgene

Today is the expected closing day of the merger between Celgene (NASDAQ:CELG) and Bristol-Myers Squibb (NYSE:BMY). All regulatory approvals have been received so there is basically nothing anymore that could derail this deal. Bristol-Myers is acquiring the company for one share of stock, a $50 cash payment and a CVR that will pay an additional $9 dollar if, and only if, three treatments that are in development receive FDA approval. With CELG trading at $107.80 at the moment of writing and BMY trading at $55.70 investors can buy the CVR for $2.10.

A hint that this might be on the cheap side can be found in this SEC filing made by Bristol-Myers in May earlier this year where the company puts an estimated fair value of $3.83 on the CVR. They don’t provide an break down how they arrived at this value, only this:

The preliminary estimate of the fair value of the CVRs was determined by applying a probability weighting to the potential $9.00 per share payment reflecting the probability of achieving all three necessary approvals. The probability-weighted value was then discounted to present value using a credit risk-adjusted discount rate.

Since that time all three treatments have progressed as planned, so presumably if they would redo this valuation today it would be higher. The three approvals that they need to get are:

  • Ozanimod (by December 31, 2020)
  • Liso-cel (JCAR017) (by December 31, 2020)
  • Ide-cel (bb2121) (by March 31, 2021)

These deadlines seem to be tight, and the combined probability of three events happening is obviously quite a bit lower than the probability of individual events, so there is reason not to be too enthusiastic about the CVR. But these treatments are all in a very developed stage of development, and the base rates of success of going from Phase III to approval or from NDA/BLA to approval are quite high. Celgene gave the following update with regards to above treatments when the company announced their results for the third quarter:

I’m not a medical expert, but given that base rates for success at this point are pretty high I think you could even make a case that the $3.83 valuation made by Bristol-Myers is somewhat conservative. These are all events that should be in the range of 75%-85% or something like that and taking very crudely 75%^3*$9 gives us a value of $3.80. This ignores that time value of money, but given that the deadlines are all relatively soon I think that doesn’t matter too much.

Because the deal will close very soon and I think that right now the CVR is probably attractively priced I bought a significant amount of CELG with a corresponding short position in BMY.

Disclosure

Author is long CELG, short BMY

Sanofi CVRs litigation settlement agreement arbitrage

When Sanofi (NASDAQ:SNY) acquired Genzyme back in 2011 it issued tradable contingent value rights (NASDAQ:GCVRZ) that would payout when meeting certain regulatory and sale milestones. Despite high initial expectations none of the milestones were met, and at some point it looked extremely likely that the CVRs would expire worthless. However, some CVR holders went to court arguing that Sanofi didn’t fulfill their obligations under the agreement. Apparently their argument had some merit (I never followed these CVRs that closely to be honest), and yesterday Sanofi announced that they would settle and pay a total of $315 million.

Sanofi logoThe trustee estimates that this would translate into approximately $0.88/CVR after paying all fees, but is unable to provide an exact number at this time. With the rights trading at $0.84 yesterday I couldn’t resist picking up a couple of them since this implies a spread of 4.8% which I think it quite generous for something that should be more or less a done deal. They will need to get court approval for the settlement, but I don’t think there is much that can go wrong nor should it take that much time. It’s a very straightforward situation at this point, and combined with a decent spread I think it makes a good bet.

Disclosure

Long GCVRZ

An update on Conduril

I bought my first shares in Conduril in 2012 for €22/share, and now, almost 7 years later we are roughly back to where I started with shares trading at €25. It hasn’t been a total dud though, because in that period the company did payout a total of €9.50/share in dividends. I was also lucky enough to sell a large part of my position in 2014 and 2015 between €65 and €80/share when I saw deteriorating results appearing on the horizon. It has been a while since I wrote about Conduril, and with the publication of the 2019 interim results I thought it was a good idea to publish a quick update, starting with an updated overview of the historical financials below:

Historical income statements Conduril

When I bought my first shares on Conduril the company was doing pretty well, earning in some years more than €20/share, but the past years the results have been more modest. Last year the company reported €1.69/share in earnings which was actually a small miracle considering that they lost €9.15/share in the first half of the year. The first half of 2019 was also pretty bad with a loss of €4.52/share, but based on the language in the interim report the company is confident that this year will be better than last year. Given that the backlog has increased from €300 million at the end of the year to €600 million now, that might be a fair assumption. In the period between 2009 and 2014 Conduril was on average earning €16.70/share per year while the average backlog was €618 million. So it could be on the edge of turning things around.

While things seem to be turning around for the construction business itself, there is also a balance sheet aspect to the story. Conduril is at the moment a classic net-net with NCAV/share of €28.70 versus the current €25.00 share price. This number is excluding €89.8 million in “other financial assets” that are recorded as non-current assets on the balance sheet. Adding this to the NCAV would result in a value of €78.58/share. So besides the stock currently trading at a 4x P/E-ratio there is also a good amount of asset backing.

Unfortunately, there are some potentially losses hiding in the “other financial assets” that erode to some extent the asset backing that this stock has. Conduril has made a €13.2 million investment in the “Rotas do Algarve Litoral, S.A.” and a €20.3 million investment in “SPER, S.A.”, two toll roads in Portugal. The “Rotas do Algarve Litoral, S.A.” is facing legal troubles because the “Tribunal da Contas” declared the original contract invalid, and “SPER, S.A.” is possible facing the same. “Rotas do Algarve Litoral, S.A.” is seeking the recover the full amount of the investments from “Infrarastruras de Portugal”, the party that seems to responsible for this mess, but of course, what the outcome will be is highly uncertain and could take a long time. Writing down both Conduril’s investments to zero would leave us with an adjusted NCAV of €59.80/share.

Conduril has one of the rare companies where I have always been enthusiastic about its valuation. Sure, things haven’t gone great the past few years, but at the current price it is just really cheap. Even without factoring in that things look to be turning around it is trading at a 4x P/E-ratio, 0.22x book and a sizable discount to (adjusted) NCAV. But who knows, after seven years I could also just be wrong about this…

Disclosure

Author is long Conduril

Nzuri Copper merger arbitrage

A merger that I have had a small position in for some time, and recently bought more of, is Nzuri Copper Limited (ASX:NZC). The company is being acquired by Chengtun Group (SHA:600711) for A$0.37 in cash while it is currently trading at A$0.31 for 19.4% spread. That’s a big spread, but when we are talking about an Australian listed company that has a mine in Congo and that is being acquired by a Chinese company I think it’s clear why many investors aren’t trilled to get involved. While the spread has always been quite big since the deal became public news, it got bigger again when the company announced last week that Chengtun is expecting delays in receiving regulatory approvals in China.

I simply don’t think that those approvals represent a huge risk. China has a long history of acquiring natural resources in Africa, and this acquisition fits perfectly in their long-running strategy. In the press release Chengtun Group also seems pretty optimistic about the regulatory approvals. They expect them to get them at the end of August, which is just a one month delay, and they state that they have no reason to believe that the approvals will not be provided:

“Chengtun Group has submitted all of the applications and ancillary documentation required to obtain the PRC Regulatory Approvals, and has attended to all further requests for information in relation to those applications received to date.

Chengtun Group understands that its applications for the PRC Regulatory Approvals are being processed, and as at the date of this announcement, Chengtun Group has no reason to believe that the PRC Regulatory Approvals will not be provided.

Of course, this requires a bit of trust in what a Chinese company is saying. I don’t see any reason to really doubt this, but at the same time, you never know for sure what is going on in China. But given the very big spread I think you are compensated more than enough for some risk, and I think the other aspects of the deal shouldn’t pose any problems. Chengtun can pay the acquisition in cash, they got regulatory approval in Congo already and shareholder approval should be a formality. At the same time the stock is also not trading a big amount above the pre-deal price, so downside risk in case of the deal breaking should be acceptable. I’m not betting the farm on this deal, but I think it’s pretty attractive.

Location of Nzuri's Kalongwe Project in Congo

Disclosure

Author is long Nzuri Copper