Traveling

I was traveling part of this week. Expect a new post tomorrow.

Apple - Falling Fruit

Shares in Apple, Inc. (tkr: AAPL) have fallen approximately 6% since last Wednesday. This fall is presumably the result of several interesting new stories that have broken over the last week. Last Thursday the National Enquirer published several pictures of Apple's founder, Steve Jobs, looking frail and exhausted as he left the Standford Cancer Center. Along with the pictures, the Enquirer ran an article claiming that Jobs has just six weeks to live. Then, on Friday, the Wall Street Journal reported that the Justice Department and FTC have begun to investigate whether Apple's recent changes to its app store, which require that application developers offer an "in app" option to purchase content, giving Apple a 30% cut, violate antitrust laws.

According to The Street, over 100 hedge funds have closed out or reduced their positions in Apple recently, while about 30 funds took new positions or extended their existing positions in the company. Though there is clearly not a consensus among hedge fund managers as to the future of Apple's share price, three times as many hedge funds are bearish and have sold their long positions. So, which side is right, the bulls or the bears?

Apple's fundamentals have not changed over the last week; it still has about $60 billion in cash, it did not lower its quarterly guidance and it's still a profitable company. The recent sell-off is simply due to speculation about Apple's future, a future which I consider to be as bright as ever.

Yes, Jobs is sick and, if the Enquirer is correct, he may die soon. His death would be a huge loss to the tech industry as a whole. I don't want to belittle Jobs's possible death - he is a hero of mine - but I don't think it would severely impact Apple's operations. On January 17th of this year, Apple announced that Jobs would be taking a medical leave of absence so that he could focus on his health. According to the announcement, Jobs remains CEO and is still involved in strategic decisions, but Tim Cook, Apple's COO, is responsible for day-to-day operations.  This was not the first time that Jobs took such a leave of absence - on January 14, 2009, Apple issued a press release strikingly similar to the one from this year. Apple did just fine in 2009, and it's doing just fine now. Steve Jobs is not Apple.

While we don't know who would replace Jobs if he were to leave Apple for good, three possible choices come to mind: Tim Cook, Peter Oppenheimer - Apple's CFO, and Jony Ive - Apple's Sr. VP of Industrial Design - all of whom have been with Apple for over a decade. It's likely that Cook would be tapped as CEO, especially considering that Jobs has selected him twice to run day-to-day operations. With the operational aspects of Apple in safe hands the question arises, "who would replace Jobs as the visionary leader of the company?" The answer is clear, Jony Ive. Ive was the lead designer of the iMac, PowerBook, MacBook, iPod, iPhone and iPad. In other words, he has worked on every major Apple product released in the last decade. In short, even if Jobs left Apple, it would still be competently manged and capable of producing innovative, market-leading products. 

The second major point of speculation that drove the decline of Apple's stock was the Wall Street Journal's story that the DOJ and FTC have begun a preliminary investigation into Apple's recent changes to its app store. There is little reason for investors to fear such an investigation - no outcome would cripple the company. If the government begins a full-bore antitrust investigation Apple will rack up millions in legal fees, but that's just a drop in Apple's $60 billion bucket. In the worst case - the unlikely event that the government concludes that Apple violated anti-trust laws - the government would probably fine Apple for the violation, require it to refund the 30% it gets from in app subscriptions and require it to change its app store policies to allow apps without in app subscriptions. These punishments would not hurt Apple much in the long-run. First, Apple can afford a fine. Second, requiring a refund of in app subscriptions/cutting off the in app subscription option would simply deny Apple a revenue source which it did not have until this month anyway. In short, the worst case is that Apple loses a source of revenue which didn't exist until this month, and it is forced to spend some of the cash it has available in its huge warchest.

The Play:

Disclosure: I have a long position in Apple which I have held for several years.

At this point, I would wait a few days to see if Apple's stock continues to slide. Once it bottoms out, take a long position and hope that it continues to have superlative performance. 

Watch the media: Apple's annual shareholder meeting is tomorrow. You may get some guidance from the meeting.

Kinder Morgan - Pipeline to Profits

On February 11, 2011, Kinder Morgan, Inc. (tkr: KMI), a pipeline company, offered 95 million shares of common stock at $30 per share in an initial public offering on the New York Stock Exchange. The stock closed up over 3% on the day at $31.05. Since that time, KMI has declined to just under $31.

KMI's IPO allowed investors, consisting primarily of hedge funds, including Highstar Capital LP, The Carlyle Group and Riverstone Holdings, LLC, to realize their profits. According to KMI's press release, issued on the 11th, no members of KMI's management sold shares through the IPO, and KMI did not receive any of the proceeds generated by the IPO.

KMI's most recent 10-Q, for the period ending September 30, 2010, paints a confusing picture. The company's net income for the nine months ended September 30 declined from $367.9 million for the 2009 period to a loss of $104.3 million for the 2010 period. Likewise, for the third quarter period net income declined from $122.8 million in 2009, to just $10.6 million in 2010. In contrast, total revenues for the third quarter increased from $1,712.3 million in 2009, to $2,088.2 million in 2010. Clearly, the sharp decline in net income is not due to slowing business. A large portion of the discrepancy can be explained by the expense line entitled "General and administrative" ("General Expense"), which increased from $92.2 million in 2009, to $308.2 million in 2010. 

The increase in the General Expense category, however, was an anomaly attributable to a one-time charge taken during the 3rd quarter of 2010 - $200 million that is related to a settlement of litigation that arose several years ago when KMI was taken private. Without this charge, KMI would have net income of $210.6 million in the third quarter. While this one-time charge clearly affected KMI's bottom line, it is likely that another one-time charge will be reflected on KMI's upcoming financial statements, this time for expenses related to KMI's IPO.

KMI also carries significant debt of $14,760.2 million. Of this, $2,454 million is short-term debt. While KMI is carrying significant debt, it is solvent and it has been able to cover or renegotiate its debt thus far. If, however, KMI's net-income decreases significantly, it could be forced to take on more debt.

The Play 

While KMI has a significant debt load, the future of its business looks good, so long as it can avoid significant one-time costs. I would consider buying KMI stock. However, buyers may face short-term losses, depending on commodity prices, which can heavily impact KMI's business, and the costs associated with KMI's IPO that are reflected on its next financial statements. In the long run, KMI is probably a good buy, which the average length of its pipeline contracts being approximately 8 years, plenty of time to pay-down short-term debt, renew its pipeline contracts and to expand its business.

Borders - Bounding Towards Bankruptcy?

A little over a week ago, Borders Group, Inc., (tkr: BGP) announced that it would delay payments to several vendors that are critical to its business, including landlords, product wholesalers and publishers, for the second month in a row. Prior to that announcement, on January 15, 2011, the Wall Street Journal reported that Borders had hired the law firm of Kasowitz, Benson, Torres & Friedman to assist it in obtaining a new line of credit from GE Capital of about $500 million. The new line of credit would replace Borders's outstanding lines of credit, and be used to pay down some of its senior debt and give it additional operating capital to be used while it restructures its business out of court.

Unfortunately for Borders, but perhaps creating a special opportunity for investors, on February 4th, Borders filed an 8-K with the SEC, notifying investors that on January 28th, Borders had received a notification letter from NYSE Regulation, Inc., that its stock's 30 day average closing price was $0.97 per share, $0.03 below the minimum trading price of stocks listed on the NYSE. If Borders's stock's 30 day average closing price does not increase above $1.00 per share over the next six months, the stock will likely be delisted. In addition, the 8-K also noted that, if Borders's stock is delisted from the NYSE, Borders will be required to payout an undisclosed sum pursuant to a warrant agreement through which it had issued warrants to acquire 25,944,236 shares of Borders stock to Pershing Share Capital Management, L.P. and its affiliates. Borders's most recent 10-Q estimates the value of the payout to be $25.7 million.

Will Borders stock be delisted, triggering the warrant payout? Probably. The six-month high for Borders stock is $1.58, achieved in early October, 2010, while the stock has only eclipsed the $1.00 mark once since Borders first announced that it would defer payments to vendors in early January. Further, Borders stock has fallen over 30% during the last 52 weeks. Put simply, Borders is trending down. However, if Borders acquires a new line of credit, thus delaying the prospects of bankruptcy, it is likely that its stock would see some rebound (though likely small considering the company's terrible financial state as reported on its most recent 10-Q).  I think it is unlikely that Borders will acquire a new line of credit, especially considering that, according to the Wall Street Journal, several publishers (whose blessing is almost certainly a prerequisite to a new line of credit) question the long-term viability of Borders's strategy.

Borders has apparently offered to sweeten the deal to publishers by offering them interest-bearing, collateral-back notes in exchange for forgoing payments in the short-term. I question the value of any such notes to publishers.

Borders's most recent 10-Q, for the period ending October 30, 2010, notes that its current credit facility with Bank of America (that will supposedly be replaced by the GE Capital credit facility) is secured by a first priority security interest in substantially all of Borders's inventory, accounts receivable, cash, etc. At the time of the filing, the outstanding amount owed under the BOA credit facility was approximately $295 million; it is likely that this amount has been accelerated and is due in full. While the GE Capital line of credit would replace that of BOA, it is likely that the GE Capital line would be secured in a similar manner as the BOA credit facility. Additionally, Borders has a term loan with GA Capital, LLC, that is secured by a second priority security interest in the same general assets as the BOA line of credit. At the time of filing, there was $57.8 million outstanding under the term loan agreement, due in 2014; however, it is very likely that this loan is in default and has been accelerated. The 10-Q lists "trade accounts payable," which would be comprised of amounts owed to publishers and other vendors, as $444 million. Borders also lists "other long-term liabilities" as $346.9 million, part of which is comprised as the payout value of the Pershing and other warrants. It is not clear what composes the rest of the amount reflected under "other long-term liabilities." The total outstanding liabilities listed on Borders's 10-Q is $1397.4 million. 

Borders lists total assets of $1356.6 million, of which $895.8 million is inventory. Borders's total outstanding liabilities that will almost certainly have priority over any notes issued to vendors (the BOA credit facility, GA Capital term loan and taxes) are valued at $386 million, leaving $509.8 million to satisfy the approximate $444 million outstanding to vendors, or about $65 million in excess of what is owed. However, I think it very likely that the liquidation value of the outstanding inventory is much lower than as listed in the 10-Q, so vendors would probably have to look to other of Borders's assets for satisfaction of their notes. Borders's 10-Q lists over $320 million in property and equipment, but makes no explanation of what composes this number, it also lists amounts for cash and accounts payable (neither of which Borders likely controls at this point considering their probable default on the BOA credit facility). In short, it's hard to say what, or how much benefit Borders's vendors would get by accepting notes for deferred payment.

It is clear from Borders’s 10-Q that its finances are in shambles and that it is facing a liquidity crisis. Where there is crisis, there are special opportunities.

The Plays:

So, knowing everything above, what sorts of special opportunities are there?

1. Short Borders's stock. If Borders does not successfully open a new line of credit from GE Capital, the company is probably totally illiquid, and will be forced into bankruptcy. Now is a good time to short Borders’s stock, though be careful to close any short position before the stock is delisted to avoid the headache of closing a delisted stock.

2. Consider buying claims from entities that would have 503(b)(9) claims. Section 503(b)(9) of the Bankruptcy Code gives priority status to amounts owed on goods delivered in the 20 day period before bankruptcy. It is hard to estimate when Borders would file, but it will probably have to soon if it does not get a new line of credit. The real risk here is buying a claim that arose before the 20 day period and being stuck with a general unsecured claim. 

3. Attempt to purchase secured debt at a discount, though it is probably difficult to do so. Borders probably has enough in assets to cover its first and second lien debt in full, even in a liquidation situation. Though, as always, there is risk.