What's Next for the Oil Risk Premium?

Crude prices soared after the situation in Libya escalated at the end of February. The sustained price increase since the conflict erupted is not justified by the amount of production displaced by the conflict. Libya exports 80% of its 1.6 mmbpd of production, so the supply shock is about ~1.3 mmbpd. OPEC has about ~5 mmbpd of spare capacity. When oil prices increased to $145 / bbl in the summer of 2008, Saudi Arabia boosted output to 9.6 mmbpd, well above the current output of 8.3 mmbpd. Notwithstanding capacity additions (which have been significant), Saud Arabia can cover the entire Libyan deficit by itself with spare capacity of 3 mmbpd. There is also significant refining spare capacity in Europe. Though heavy / light differentials will (and have) increased due to the quality difference between Libyan and Saudi oil, crude and product prices have gone higher than justifiable on a supply / demand basis.

Crude has moved further than justified by fundamentals due to the risk of further conflict. Nigerian elections are coming up this quarter and the severity of Syrian protests are growing. But the key driver is undoubtedly the tail risk of conflict escalating in Saudi Arabia itself.

Assuming a fair value crude price (Brent) of $90 / bbl implies a risk premium of around $30 (with Brent around $120-125). The uncertainty of what future conflict might look like makes it difficult to evaluation the value of the risk premium, but the relationship should look as follows:

It's difficult to take a strong stance on whether this risk premium is justified (my gut reaction given the implied probabilities is that the risk premium is overstated). I think a better question is how long does oil deserve this premium? It's hard to see a reason why the premium will disappear as long as we have headline grabbing news from the Middle East. The problem is that there are so many conflicts - Libya being merely the most conspicuous - that a risk premium may be warranted for an extended period. So while the value of the risk premium may be overstated, the premium may endure for longer than those focused on the progress in Libya might expect.

What I'm Reading...4/21/11

Happy Thursday.

Reactions to Finnish parliamentary elections continue to trickle in as if the rise of nationalism in Europe is a great surprise. A blogger at the BBC described the strong showing of the True Finns (19%) as "a tremor hit[ting] the EU" (BBC article link). But growing nationalism in the EU is hardly a new development. (I wrote in June 2009 about the rising nationalist sentiment evident in European Parliamentary elections.) The drastic decline in popularity of the German FDP and concurrent rise of the German Green party (as manifested in the Green Party's historic win in Baden-Wurtemberg) are a case in point. As is the emergence of the Tea Party in the US or Marine le Pen and the Front National in France.

I would argue that we aren't seeing a vast movement to the right, but rather a further bi-furcation of political attitudes. In France, rising support for the Front National comes at the expense of the Sarkozy's UMP. Similarly, rising support for the Socialist party comes at the expense of the Green party and various French leftist parties. In the US, according to gallup Party ID is historically range bound in the US, with 30-40% of the US population identifying themselves as Republicans or Democrats. What fluctuates significantly more is the percentage of Dems/Indies/Repubs who think their parties are too liberal/conservative. Either way, the strong showing of the True Finns is unlikely to disrupt the Portuguese bailout as the pro EU National Coalition Party has already declared support for the Portuguese bailout as unconditional. Sure, the National Coalition Party will have to make concessions on other issues, but bailout will survive. That being said, debt investors seem to have realized just recently that they will likely take a haircut on their debt. The uncertainty of a debt restructuring is far scarier to me than rising nationalism, no wonder gold hit an all-time high today.

On an unrelated note, the WashPost has an article out today questioning China's "green leap forward." I was unaware that most of China's investments in green technology ultimately target Western markets. For example, Chinese investments produced half of the world's production of solar panels in 2010, but 99% of these panels were installed in foreign countries, presumably to those that subsidize these installments, such as Europe and the US.

"A green future will result not from subsidizing immature technology today but from developing competitive green technology that is effective and cheap. Wind and solar power are not yet competitive. Research would be a much better investment for Western countries than subsidizing imports of today’s green technology from China."

Well put. It reminds me of another report I read today (admittedly- only skimmed) that discusses the failure of the Climate Action Partnership to successfully push climate action despite out-fundraising conservative advocacy organizations 11 to 1 (and outspending on climate change related projects 44 to 1). I haven't had the time to go through it in full yet (its probably 100 pages long), but looks very interesting (ClimateShift "Clear Vision for the Next Decade of Public Debate").

It's hard to comment on news this week without mentioning Trump. It's easy to dismiss Trump's candidacy as a joke, but mainstream Republicans have reason to be worried. While his "birther" focus may not be a legitimate campaign platform for a national election, among Republicans his views align with the majority. A recent New York Times poll concluded only 32% of Republicans believe Obama was born in the US. Up till now, Trump is the only Republican candidate with a wide public recognition who relentlessly attacks not only Obama's policies, but even his legitimacy as President, a lingering issue for many conservatives. No other candidate has gotten as much traction among primary voters, with Gallup's new poll showing Trump tied with Huckabee for the 2012 Republican nomination.

Let's also not forget that seemingly ridiculous beliefs such as the birther issue are common among opposition parties. Ben Smith recently commented that the birther issue is to Republicans as the 9/11 "inside job" conspiracy theory was for Democrats. A full 22.6% of Democrats said it was "very likely" and another 28.2% called it "somewhat likely" that Bush either assisted in the 9/11 or took no action to stop the attacks.

I'll leave you with one last link. Hat tip to Mr. Felix Salmon for a link to a fascinating paper on global beer consumption trends (Felix Salmon's summary).

China moves up the value chain

According to Dealogic, outbound Chinese M&A has totaled $24bn year-to-date. If this level of activity were to continue for the rest of the year, total 2011 outbound M&A by Chinese companies could reach $100bn, almost double 2010 numbers.

The overarching trend of the last 5 years has been an increased focus on natural resources companies. Outbound acquisitions by Chinese companies targeting the mining space have increased from 6% of total deal volume in 2006 to 34% in 2011 YTD. Oil & Gas has accounted for 30-40% of total outbound M&A volume for the last three years.

This trend is also reflected in the target countries with resource-rich Australia and Canada recently becoming the most targeted countries.

To what extent can we expect these trends to continue? As long as state-owned Chinese companies have a mandate to secure resources, we can expect cross-border mining and oil & gas activity to make up the vast majority of deals. But the massive surge in natural resources focused activity masks other equally important trends.

Recently, Chinese outbound M&A targeting higher value sectors has ticked up markedly. M&A targeting Healthcare companies is up from $0mm and $253mm in 2006 and 2007 to $603mm and $204mm in 2010 and 2011 YTD, respectively. On an annualized basis, the number of transactions targeting Healthcare outbound Chinese M&A is up 400% from 2007. Almost all of this activity has targeted the pharmaceutical or instruments sector within the Healthcare industry, which are significantly higher-value sectors than other verticals within Healthcare such as the care or products verticals.

M&A targeting computer & electronics companies has also increased significantly. Deal volume targeting these companies totaled $1,326mm last year (34 deals) compared to $406mm (12 deals) in 2006. If 2011 activity continues at its current pace, total 2011 deal volume could reach $2,000mm.

Though these increases can't compare with the increase in natural resources focused activity, in some ways these trends are more important. The amount of Chinese M&A targeting higher value-added sectors such as pharma and electronics is a valuable datapoint to tracking the nature of China's economic development. It is only logical that over time Chinese industry will increase its presence in higher value-added industries currently dominated by Western and Japanese/Korean companies. What might be surprising, however, is the pace at which this is already happening.

Note: my Dealogic dataset includes all announced M&A by Chinese companies where the target nationality is not Chinese.

Strongest quarter for LBOs since the credit crash

According to Preqin, Q3 2010 witnessed 498 pe-backed deals worth $66.7 bn, up 29% from Q2 and 300% from Q3 2009.

Fundraising is also up this quarter:

Bain's LBO of Gymboree looks like a slam dunk

When I read this morning that Bain Capital was buying Gymboree Corp. (GYMB) for $1.8 billion, I had never heard of the company. After reading through their 10-K and going over their stock performance, I was surprised Gymboree (a specialty retailer of children's clothing) had not been bought out earlier. This company is an almost perfect LBO target!

Existing debt consists of only about $70mm in leases. Cash flows are extremely stable. Revenues have not declined once over the last decade, growing 11% on average over the last five years. Also, over the last few years as growth has slowed, margins have improved and the company has reduced its operating leverage considerably in comparison to the earlier half of the decade. Gymboree is also less cyclical than other retail companies, possibly due to the fact that in hard times parents will rather cut their own expenses than those of their children. Finally, it's likely that improvements to GYMB's cash conversion cycle could dramatically increase value. If Bain manages to increase payable days and decrease inventories, Gymboree could possibly enjoy negative operating working capital and certainly increase free cash flow to pay down debt.

My analysis below breaks down how this LBO might work. There's obviously a lot about this LBO that we don't know yet, such as leverage, debt pricing, refinancing, and what happens to the existing cash on the balance sheet. Flipping the lease refinancing and special dividend switches in the model changes Bain's expected IRR by 10%. But even then (at 13% IRR), this is still a great LBO given my conservative assumptions (3% revenue growth, lower margins than in recent years, no multiple expansion).

If I were a merger arb, I might even consider betting another (probably financial) bidder will trump Bain's offer.

Gymboree LBO Model com

What Sara Lee tells us about the current LBO environment

About a month ago, KKR allegedly offered to buy Sara Lee for $12B, though Sara Lee's board spurned the buyout firm's advances. It's easy to see why Sara Lee might be an attractive LBO target -- it's not too leveraged, has strong brands and significant opportunities for operational improvements. My analysis (see below) shows that KKR could reasonably expect double-digit returns even if sales growth remains low. So why has KKR not raised its bid or gone hostile?

Given whats happened in the markets we should expect a sharp increase in sponsor activity. The financing market is in great shape and vintage 2005-2008 funds are flush with capital. LBO activity is in fact rebounding as total YTD sponsor backed deals are almost back up to 2005 and 2008 levels. And yet as conditions have improved, we still haven't seen the $10 billion plus mega deals that were the norm before the crisis.

Private equity certainly seems cautious about mega-buyouts. Both potential 10B+ LBOs of 2010 (Sara Lee and Fidelity National Information Systems) fell apart because of disagreement on price. One particular reason for this caution regarding mega buyouts is the pressure on the traditional mega-fund business model. Investors especially question the fee structure of these deals and, given the poor performance of many mega LBOs over the last few years, are understandably incensed by the substantial management fees on these deals.

According to Prequin surveys, a majority of LPs are reconsidering their allocation to large PE funds with some notable firms like Blackstone even returning previously paid fees. Now, with PE fundraising still weak, buyout firms are under pressure to prove their mega LBOs generate superior returns and deserve management fees of 1% or higher. The deals done today may prove to be critically important to securing funding in the future.

My analysis below shows that, although Sara Lee is an attractive LBO at $12B, those returns quickly disintegrate as price increases. In fact, price is more important to generating a return (on a percentage basis) than cost of debt or EBITDA growth.

The model below can also be downloaded as an excel file here. The operating model uses historicals to project EBITDA growth and Cash Flow / EBITDA.

Sara Lee Analysis

3G LBO of Burger King

3G's $3.3B ($4.17B total transaction value) LBO of Burger King is one of the most high-profile LBOs of 2010. This LBO is interesting for a number of reasons. For one, the acquirer, investment fund 3G (funded by a small group of Latin American billionaires), is not a part of the usual suspects one would expect to see on a deal of this magnitude. Also different from most LBOs, 3G has stated it is buying Burger King for the long-haul and is willing to wait 10 years before exiting.

The choice of Burger King is also a strange one. When BK was bought out by Bain, GS, and TPG in 2002, Burger King was an insignificant and unappreciated holding of the food and beverage behemoth Diageo, allowing the sponsors to acquire BK at a very favorable valuation. But the Burger King of today is much different. Eight years of sponsor ownership have turned BK into a lean company with few easily realized cost reductions. Furthermore, from a strategic point of view, BK has fallen far behind its rival McDonald's and requires massive amounts of capital expenditures to compete (estimated in a recent Bloomberg article to be as high as $3 billion). For more on the challenges facing 3G, go here. Perhaps most surprising is the valuation. 3G did not pick up BKC on the cheap, paying 9.4x LTM EBITDA and 8x LTM net income.

My model of the LBO is posted below. I suggest you do not try to look at it on Scribd but instead go here, and download the excel file. My analysis shows that using conservative growth assumptions and moderate cost cutting assumptions, the Burger King LBO could return 16% annually if 3G exits in five years at the same valuation (9.4x EV/EBITDA) at which it entered.

However, this return is very sensitive to Burger King's ability to cut costs, which is questionable given the rising costs in the industry as well as BKC's previous ownership (Management also expects SG&A to increase by 3% in 2011). If one assumes Burger King has to boost capex to 10% of sales and SG&A as a % of sales increases by 3%, the 15% IRR quickly disappears, even with above trend top-line growth.

That being said, I actually think this deal was a good idea for 3G if 3G manages to leverage its experience in Latin America to grow Burger King quickly in emerging markets. As Burger King grows internationally, its operating leverage from its restaurant ownership will deliver larger margins and significantly increase Burger King's valuation. But overall, like most recent LBOs, the success of the BKC LBO is heavily dependent on exogenous forces. 3G is blessed to have patient investors. It's longer term investment horizon will allow it to wait for an opportune time to exit -- which can make all the difference.

Burger King LBO Model