Wsh's  Instablog

The Wall Street Journal published an article on December 11^th, 2010 about State of Illinois’ move to pitch plans to large investment banks and hedge funds in order to finance its obligation to vendors. The article can be found at the following link:

In short, the State owes about $4.5 billion to vendors of different sizes, many of which depend on state contracts for their survival. Yet like many other states, Illinois faces tax shortfalls and increasing pension obligations and does not have the cash to pay the vendors on time. Therefore, the State attempts to raise cash from the capital market to meet its vendor obligations. According to the illustrations on WSJ, for every month the State falls behind its vendor payment beyond 60 days, investors will collect 1% penalty. Since the State is currently 5 months behind its vendor payments the investors will expect to collect 3% initially and get 1% penalty for every additional month until the State pays back the money. State officials expect to pay back investors in 6 months, although there is no guarantee of that.

I don’t have additional information with regard to how the discussion between Illinois and the potential investors have progressed and other intricate details. However, I would like to present my opinion about whether this will be a good idea for investors. Please note that this opinion is developed based on very limited information. For this article, I will refer to the debt described above as the Vendor IOUs.

The investors in these Vendor IOUs are exposed to two main risks:

1)      The State may default on the Vendor IOUs. The State’s ability to pay principal and interests on the Vendor IOUs will be supported by its ability to tax. Therefore, in terms of credit quality, this should be similar to a General Obligation debt. The State of Illinois’ general obligation bonds are currently rated A+/A1 by S&P/Moody’s and we can assume that the credit quality of these Vendor IOUs to be at least investment grade. The more important point is, unlike cities and counties, by Constitution, a State cannot declare bankruptcy and therefore by law must pay back its obligations sooner or later.  

2)      The payback of Vendor IOUs may take longer than expected. This risk can be mitigated partially by Illinois’ proposed funding structure. According to the plan illustrated in the WSJ article, upon issuance of Vendor IOU, only 90% of the proceeds will be paid to vendors and the remaining 10% will be put into an escrow account. If the State has not repaid the investors after one year, funds in the escrow can be used to pay interest on the Vendor IOUs. This provides a little more security for the investors, although the majority of the principal will still be exposed.

From a Returns perspective, Assume the State takes about 6-12 months to pay back Vendor IOU, investors may be rewarded with 9-15% annualized return. In addition, municipal debt are federally tax exempt, assume a 25% marginal tax rate, the Vendor IOUs will offer an equivalent taxable return of 12-20%. As of end of December 2010, 1 year Treasury bill yields about 29bps, the Vendor IOUs can potentially provide a huge risk premium over Treasury. That is very impressive for an investment grade rated debt.

In addition, for investors concerned about a rise in general interest rate level, the Vendor IOUs may offer a place to temporarily park money with attractive returns and low reinvestment risks. The Vendor IOUs are short term in nature (less than 12 months) but the monthly step-up in interest rate can more than keep pace with a potential rise in general interest rate level. If the general interest rate level actually rises in 12 months and the State pays back the principal within that period, investors can reinvest the proceeds into higher earning assets.

Overall, in my opinion, the Vendor IOUs offer quite attractive reward for risks involved with investing in such obligations.

In “The Opposite” episode of the Seinfeld show, Jerry stated that “Salmon is the opposite of the tuna, ‘cos salmon swims against the current, and the tuna swims with it”. If that is true, then ExxonMobile could be serving of delicious salmon on your portfolio plate.

On December 23, 2010, ExxonMobile agreed to pay $650 million for Petrohawk Energy Corp.’s natural-gas wells and pipelines in the Fayetteville Shale, its second shale purchase this year after its $35billion purchase of XTO Energy. The whole commodity market is bearish on natural gas, with abundant supply, increased production and swelled reserves. Natural gas future price is down more than 20% from a year ago and the market seems not to expect it to recover any time soon. In the meantime, oil prices have been on a tear, topping $90 right before Christmas of 2010. No wonder natural gas producers are buying oil assets and diversifying into oil.

In the meantime, ExxonMobile has been playing salmon consistently and taking advantage of the declining natural gas prices. It paid PetroHawk $1.92 per thousand cubic feet for the reserves at Fayetteville, 36% lower than what it paid for XTO. The move has been based on belief that natural gas will be the fastest growing energy source for the next few decades and it is obviously betting on a recovery of prices in natural gas.

Its strategy certainly may have merits. Just take a look at the available energy sources. Oil and coal have long been condemned as the dirty sources of fuel. Yet renewable energy sources, such as solar, are slow to catch on due to substantial upfront costs and uncertainly with government assistance programs. It can be expected that in the near term, with a lot of governments running large deficit, subsidies for renewable energy may be on the decline. Natural gas is a clean burning source of fuel, yet it is mature and can easily be utilized. Despite all the hype about renewable energy, the low-profile natural gas is the easiest way to achieve environmental goal without huge investments.

While they have not done that, with natural gas price continues to fall, natural gas producers will have to slow down production and therefore reduce supply. ExxonMobile’s strategy of buying natural gas reserve on the cheap has a good prospect of paying off in the near future. Wasn’t there an old Wall Street saying that when even the shoeshine guy is giving stock tips, it is time to sell? When the whole market is bearish on natural gas, ExxonMobile’s move may have just provided a course of tasty salmon on the menu.

1/21/2010

 

There are a few reasons to invest in Hotel REITs now:

 

 

Among the hotel REITs, I believe the ones that focus on catering to business guests will likely benefit first from an economic recovery as business spending will be at the same pace as economic recovery, while job growth, a key driver for demand for leisure hotels, usually lags economic recovery.

 

Due to the recession, a lot of weaker and/or overleveraged hotels have been forced into foreclosure and there are plentiful of bargains in the industry. I believe smart REITs, with strong balance sheet, large cash reserve and excess debt capacity, will likely be able to take advantage of attractive valuations in the market and expand their portfolio and market share.

 

I have researched 7 hotel REITs in order to find the one(s) that has the following:

 

 

The 7 hotel REITs are:

 

 

Of the 7, I like HST and DRH. Both companies has no debt service default in their portfolio and both has strong cash positions (HST has $1+billion while the smaller DRH has $100+million). They both own mostly upscale branded hotels at desirable locations and cater mainly to business travelers.

 

During the recession, both companies have done a good job of strengthening their balance sheets by tapping the equity market. HST has also taken the measures to sell (presumably underperforming and/or non-core) hotel properties for cash and restructure some of its debt. Both companies have capacity to add leverage if necessary. In fact, 10 of the 20 hotels in DRH’s portfolio are debt-free.

 

In my opinion, a key difference between the two, apart from size, is style of management. Both have filled their corporate coffer with cash. Yet HST appears to take a more aggressive approach toward potential acquisition, while DRH appears more conservative and focuses on tightening the ship.

 

Therefore, if you are looking for a hotel REIT that can quickly take advantage of the growth and expansion opportunity, HST may be a better candidate. On the other hand, if you are looking for a Hotel REIT that is able to benefit from the economic recovery and be a relatively safe investment, DRH could be a smart choice.