Berkshire Ruminations

Thursday, December 18, 2008

Doing the math on CEG (back of the envelope)

I post this not as any type of authority, but just to figure it out for myself. Can anyone explain better than I have here why CEG stock fell yesterday?

This past summer MidAmerican Energy agreed to acquire all outstanding shares of Constellation Energy Group (CEG) at a price of $26.50 per share in cash, or $4.7 billion.

EDF came along a few weeks ago and offered to pay $4.5 billion to acquire half of CEG’s nuclear division.

In 2007, the nuclear division generated about 60% of CEG’s revenue. So, effectively, EDF was offering to pay approximately as much for 30% of CEG as MidAmerican was offering to pay for the entire company. EDF emphasized that this offer priced CEG stock at a minimum 100% premium to its market price.

Before the EDF offer, CEG stock languished at around $23.50, about a $3 discount to the MidAmerican’s cash offer price of $26.50. Upon the offer, CEG stock shot up to around $28, clearly because EDF’s offer was so superior.

Yesterday, both companies confirmed that MidAmerican was terminating its agreement to acquire CEG. As part of this termination, CEG was to pay MidAmerican a breakup fee of (approximately) $500 million plus shares equaling 10% of CEG’s equity. Upon the announcement of the termination and subsequent details of the breakup, CEG fell 12%, to less than $24/share.

If EDF is offering to pay $4.5 billion for 30% of the company, then the company as a whole should be worth $15 billion minus the breakup costs, assuming of course EDF is not overpaying. With 178 million shares outstanding, this would be about $84/share minus breakup costs.

At its current price, CEG has a market cap of $4.3 billion. In other words, it is about to sell part of one of its units for more than you could buy the entire company for today. Were you to buy CEG today you would (theoretically speaking) get all your money back upon the consummation of the EDF deal, leaving you with half of the nuclear unit and all the rest of CEG as gravy, but also with the obligation to pay MidAmerican $500 million in cash (about $3/share) as well as shares equal to 10% dilution of the stock (if we assume intrinsic value before dilution is 84 – $3 = $81 then this would be $8.10/share).

So what do we have? CEG should be worth $84 – $11.10 = $72.90? Is this right?

I think it may be, but that doesn’t make it a buy. Not in this market anyway. I mean, the stock soars when the EDF deal was proposed, then tanks when the deal was confirmed. This is just nutty.

The logical explanation for CEG’s fall yesterday is that investors simply will not buy anything in this environment that does not have an identifiable and imminent catalyst. There is value all over the place right now, so CEG is not alone with its unfairly low valuation. Because of this, and because the market is so nutty anyway, investors just don’t want to put up with owning the stock now that they know they won’t be getting their $26.50 cash payout.

These are amazing times. Ben Graham is smiling from the heavens I am sure.

Monday, December 15, 2008

Thoughts on a Big 3 "Bailout"

With so much talk, debate and controversy over the idea of “bailing out” the Big 3 automakers, I find it amazing that so little of this discussion has been on the topic of bankruptcy. The media, congress and the Big 3 CEOs seem to accept as a foregone conclusion that a bankruptcy filing would be a bad thing. This is completely absurd and I would like to discuss why.

Businesses fail in this country (and across the globe in fact) all the time. Because of this, and because chaos might ensue among creditors otherwise, we have this nifty section of the U.S. Code called Title 11 entirely devoted to the idea of the federal court system dealing with failing businesses (or individuals) and aiding in equitable distribution. This is not new – the power to codify such a thing was written in our constitution. What is new is the idea that in some instances we ought to abandon this time-tested framework and instead let Congress directly and deliberately affect the outcome of financial distress for a limited and specific group of companies. Reminder: Congress is not in the business of running businesses. (We need to remind ourselves of this these days.)

I will, for the purposes of this essay, assume that it is in the best interest of the nation to see the Big 3 survive. However, I do think very strong arguments can be made that they ought to be competed out of existence. Nonetheless, let’s assume that the job losses that would result from an outright liquidation of the automakers would be permanently catastrophic to our economy.

Under this scenario the solution is simple: File Chapter 11 like every other company that runs in to difficulty. Many pundits seem to be equating bankruptcy with corporate death, which is just not the case. Chapter 11 primarily allows a firm to restructure its capital. In the end the company comes out of bankruptcy with less financial burden. Operational changes usually occur, but that is not the point. It is a financial maneuvering first and foremost. Filing Chapter 11 does not necessarily mean any factory-line autoworker need lose his job. However, one caveat: If your job is not needed, it may (and should) be put on the chopping block as part of the plan of reorganization. Perhaps this is reason for the UAW’s opposition to bankruptcy?

What Chapter 11 does usually mean is that the CEO will get fired. With very rare exception, the existing CEO gets canned between the time the bankruptcy petition is filed and the plan is confirmed (for empirical support of this contention see Hotchkiss (1995)). This, I think, is why we saw the three CEOs fly their corporate jets to Washington to beg for help. All of them are probably not long for their posts, save perhaps for Mr. Nardelli, who could probably make the strongest argument he is not to blame for his firm’s woes. Thus, the CEOs clearly would rather not go the Chapter 11 route. And so they go before Congress to testify in front of a group of politicians that desire to be seen as the saviors of the auto industry, and who know that the majority of the American public doesn’t really understand what bankruptcy is. It’s a win-win for the powers that be. Not so much for the millions of other stakeholders.

There are two reasonable arguments against a Chapter 11 filing for the Big 3. The first is the weakest, but also the one that has been cited the most by the ignorant media. People won’t buy cars from a bankrupt automaker. Sounds bogus to me, I mean people fly on bankrupt airlines every day. But maybe it is true if potential customers are legitimately worried about the soundness of their warranty. Perhaps. But there is a logical solution that does not include writing a $14 billion check: Have the government guarantee all Big 3 car warranties for a period of time sufficient to restore confidence in the companies. Maybe until confirmation of a Chapter 11 plan of reorganization when the company will have more firm footing?

The other argument against Chapter 11 is more legitimate. This is that, once in bankruptcy, the automakers won’t be able to find the necessary debtor-in-possession financing to keep them afloat through plan confirmation. One reason bankruptcy works as well as it does is that, once the petition is filed, all subsequent debts are given priority over pre-petition debts. This is called debtor-in-possession (DIP) financing. With the credit markets tightening, it is not unlikely that the Big 3 would find DIP financing scarce. No problem! The government can't wait to lend these companies money. Problem solved.

If the government is going to provide lending to the Big 3, it ought to be under the oversight of the bankruptcy court. Congress could tell them to go ahead and file, while assuring them that DIP financing will be available from the government if needed. It seems unnecessarily arbitrary to extend a loan to a troubled company outside of bankruptcy for no other reason than that they employ many people. By structuring government involvement within the framework of bankruptcy (through a government-backed DIP loan and/or guarantee of manufacturer warranties), at least the many other existing creditors will have a voice in the direction of the companies by allowing them to vote on the plan of reorganization.

I don’t like the term “bailout” because it implies that whatever problem exists will be fixed. Congress' proposed bailout promises a great deal of bailing, but not much hope for a bail-out. I mean seriously, blindly throwing money at businesses that are losing billions of dollars every year with no real guarantee that anything will change is an awfully foolish idea for anyone, but especially the government.