The Investment Charlie Munger Waited Fifty Years to Make
The story of how the vice chairman of Berkshire Hathaway bought the distressed securities of a mundane industrial business in the depths of recession, netting an 800% return in three years' time.
After the 2017 annual general meeting of the Daily Journal Corporation, of which Charlie Munger is chairman, Mr Munger sat eating peanut brittle and answering questions from investors about a range of topics, including his past investments. One of the most interesting topics of discussion was that of an investment he described as a “cigar butt” which he purchased in 2001.
Berkshire buys Industrial Concentration
The preamble to the discussion was about Berkshire Hathaway’s interest in consolidating industries.
He was asked about Berkshire Hathaway’s airline investments, to which he remarked:
I don’t know much about it, but I do know that it’s more concentrated now, and there’s no real substitute for it. It isn’t like we have a substitute for air travel. And it’s down to relatively few players. In the old days they could always start a new airline. They hired nothing but young people, they’d pay the pilots less, they don’t have a union, and they could just start hitting the prices…they just kept ruining the business over and over again.
Munger was very clear that industrial concentration was the primary reason for the investment. He noted,
I don’t think oil prices will make that much difference. If the kerosene doubles in price, over time, I don’t think it matters much to the airline. You put a hundred people in an aeroplane and fly somewhere. It’s pretty efficient. You can do a lot of flights per day, and it’s worth a lot of money to the people who take the trip. There’s not going to be a new airport in Shanghai. A lot of the airports are fixed, and a lot of them are at capacity. It is obviously better than it was in the past. Whether it’s good enough so that we’ll do well, I don’t know. Also, if it starts working, you get paid in advance for the tickets, so there’s no credit. A lot of people lease the airliners, so if you make money, it can pile up pretty rapidly in cash.
When asked why they didn’t invest in Jet Blue, he replied,
I don’t know anything about individual airlines. Neither does Warren. We bought a bunch. It was a sector bet. It’s not a bet on an individual airline.
An astute listener asked, “when industries like airlines or railroads rationalise and turn around, how do you and Warren know?”
We don’t know. It was easy to see the railroad wind was all over when we went in. In the airlines it’s not over, but it’s a little bit the same story. Years of consolidation and bankruptcies. 3, 4, 5, 6 big bankruptcies already in the airlines.
The questioner responds, “so for fifty years you’ve continually read about these industries even though you have disdain for them?” This is when Charlie begins to discuss the investment.
[Munger:] Yes. I read Barron’s for fifty years. In fifty years I found one investment opportunity in Barron’s, out of which I made about $80 million with almost no risk. I took the $80 million and gave it to Li Lu, who turned it into $400-500 million. So I have made $400-500 million out of reading Barron’s for fifty years and following one idea. Now, that doesn’t help you very much, does it? I’m sorry, but that’s the way it really happened! If you can’t do it…I didn’t have a lot of ideas. I didn’t find them easily, but I did pounce on one.
[Audience:] Which one was that?
[Munger:] It was a little automotive supply company. Anyway, it was a cigar butt.
[Audience:] Was that K&W?
[Munger:] No. No, no…I’ve forgotten the name of it, but it was a little…it was the Monroe shock absorber, and all that stuff. The stock was a dollar, and the junk bonds which paid 11 3/8 were 35. I bought the junk bonds. They paid me the 35%, and they went right to 107 and they were called. And the stock went from 1 to 40, but of course I sold my stock at 15.
[Audience:] What did the article in Barron’s say?
[Munger:] It said it was a cheap stock! But that’s a very funny way, for me to watch for fifty years and act once.
[Audience:] How long did it take to make that 15-bagger?
[Munger:] Maybe a couple of years.
[Audience:] How long did it take you to make the decision to buy it, once you read the article?
[Munger:] Oh, about an hour and a half.
[Audience:] What was it about that company…an auto supply company…?
[Munger:] Well, I kind of knew, based on experience, how sticky some of that auto secondary market was. How many old cars needed Monroe shock absorbers. And I just knew it was too cheap. I didn’t know it would work for sure. As I say, people were afraid it was going to go broke, obviously, if their bonds were selling at 35.
Tenneco Automotive Inc.
A quick search reveals that the company’s name was Tenneco Automotive Inc. Munger would have purchased the bonds and shares in late 2001, and sold as early as late 2004. It is amusing that Munger easily recalled the precise material details of the investment, but could not recollect the name of the company. Mature investors may relate to this. But it is not quite surprising, given that the company is the survivor of The Monroe Auto Equipment Company, which bore that name for half of Munger’s life. In it’s 2001 annual report, Tenneco explains:
We entered the ride control product line in 1977 with the acquisition of Monroe Auto Equipment Company, which was founded in 1916 and introduced the world's first modern tubular shock absorber in 1930.
Tenneco was a survivor of a manufacturing conglomerate, after the spin-off, just prior to Munger’s investment, of its shipbuilding, oil & gas, and packaging and paperboard businesses:
Tenneco was incorporated in Delaware in 1996 under the name "New Tenneco Inc." ("New Tenneco") as a wholly owned subsidiary of the company then known as Tenneco Inc. ("Old Tenneco"). At that time, Old Tenneco's major businesses were shipbuilding, energy, automotive and packaging. On December 11, 1996, Old Tenneco completed the transfer of its automotive and packaging businesses to us, and spun off our company to its public stockholders. In connection with the 1996 spin-off, Old Tenneco also spun off its shipbuilding division to its public stockholders, the remaining energy company was acquired by El Paso Natural Gas Company and we changed our name from New Tenneco to Tenneco Inc. Unless the context otherwise requires, for periods prior to December 11, 1996, references to "Tenneco", "we", "us", "our" or the "Company" also refer to Old Tenneco. In a series of transactions commencing in January 1999 and culminating with the November 4, 1999 spin off to our shareholders of the common stock of Tenneco Packaging Inc., now known as Pactiv Corporation (the "1999 Spin-off"), we separated our packaging businesses from our automotive business and in connection therewith changed our name from Tenneco to Tenneco Automotive Inc.
Following the final spin-off of the packaging business in 1999, Tenneco was described as follows:
With 2004 revenues of over $4.2 billion, we are one of the world's largest producers of automotive emission control and ride control systems and products. We serve both original equipment manufacturers and replacement markets worldwide through leading brands, including Monroe(R), Rancho(R), Clevite(R) Elastomers, and Fric Rot(TM)ride control products and Walker(R), Fonos(TM), and Gillet(TM) emission control products.
As an automotive parts supplier, we design, engineer, manufacture, market and sell individual component parts for vehicles as well as groups of components that are combined as modules or systems within vehicles. These parts, modules and systems are sold globally to most leading OEMs and throughout all aftermarket distribution channels.
Tenneco’s Emissions Control segment manufactured mufflers, catalytic converters, pipe, resonators and manifolds. The company estimated its share of the US market for emissions control products for 2001 at 35%.
Its Ride Control Segment produced shock absorbers and struts. The company estimated its share of the US market for ride control products for 2001 at 52%.
In 2001 Tenneco’s consolidated revenue was $3,364 million. The percentage breakdown was as follows:
Tenneco’s revenue was sourced from the United States (50%), Europe (27%), Canada (4%), and Other Areas (19%).
Tenneco had multi-national manufacturing operations, with plants in the United States, Canada, Mexico, Belgium, Spain, the United Kingdom, the Czech Republic, Turkey, South Africa, France, Denmark, Sweden, Germany, Poland, Portugal, Argentina, Brazil, Australia, New Zealand, China, and India. We also have sales offices located in Australia, Argentina, Canada, Italy, Japan, Poland, Russia, Singapore, Thailand and Sweden.
Industry and Business Conditions
In its 2001 annual report, Tenneco discusses the evolving industry landscape. It notes lengthening replacement cycles for after-market parts, due to increasing part quality and durability, and describes this as a drag on sales growth. While ride control product revenues decreased slightly during the previous two years, emissions control product sales increased slightly. The trend in emissions control products may have been explained by increasingly stringent emissions standards.
Tenneco describes the North American and European automotive markets, where the company’s operations are concentrated, as mature, and acknowledges that its industry looks to Asia and emerging markets for growth.
It does appear that Tenneco’s brands were category leaders, and the company operated state-of-the-art manufacturing plants. Its dominant market share did not appear to be under threat from competition.
The company’s OEM customers were concentrated, with nearly 50% of sales to four leading car and truck manufacturers. In the aftermarket segment, customers were more diverse; however, they mention a trend of consolidation of aftermarket parts distributors.
CHANGING AFTERMARKET DISTRIBUTION CHANNELS
In North America, during the last decade, the number of retail automotive parts chains, such as AutoZone and Advance Auto Parts, has been growing while the number of traditional automotive parts stores ("jobbers") that sell to installers has been declining. From 1991 to 2001, the number of retail automotive parts stores has increased from approximately 10,000 to approximately 15,000, while the number of jobbers has decreased from approximately 25,000 to approximately 19,000. As a result, the traditional three-step distribution channel (full-line warehouse, jobber, installer) is redefining itself through two-step distribution and continued formation of buying groups. In addition, since retailers are attempting to grow their commercial sales to automotive parts installers, they are increasingly adding premium brands to their product portfolios. This enables them to offer the option of a premium brand, which is often preferred by their commercial customers, or a standard product, which is often preferred by their retail customers. We believe we are well positioned to respond to this changing aftermarket situation because of our focus on cost reduction and high-quality, premium brands.
Over the past few years, automotive suppliers have been consolidating in an effort to become more global, have a broader, more integrated product offering and gain scale economies in order to remain competitive amidst growing pricing pressures and increased outsourcing demands from the OEMs. Industry forecasters estimate that consolidation will drive the number of Tier 1 automotive parts suppliers from around 2,000 in the year 2000 to 150 by 2008 and the number of Tier 2/3 suppliers from around 6,000 in the year 2000 to around 800 Tier 2 suppliers by 2008. A supplier's viability in this consolidating market will depend, in part, on its ability to maintain and increase operating efficiencies and provide value-added services.
As such, although possessed of leading market share, the company was selling into concentrated horizontals within a mature industry, and therefore had limited pricing power.
Substantially all of the company’s employment contracts were subject to collective bargaining agreements.
As of March 1, 2002, we had approximately 20,145 employees, approximately 55% of which were covered by collective bargaining agreements and approximately 36% of which are governed by European works councils. Twenty-seven of our existing labor agreements, covering approximately 40% of our employees, are scheduled for renegotiation in 2002. We regard our employee relations as generally satisfactory.
The unionised labour force applied steady cost pressure.
The Tech Wreck
Judging from the information provided by Munger, his investment would have been made in late 2001. The bursting of the DotCom bubble in 2000 was followed by the attack on the World Trade Center in New York City, on 11 September 2001, and by this time the global economy had entered recession. Tenneco’s common shares hit an all-time low, on 17-18 October 2001, of $1.35.
At this time, Munger would have had the benefit of the second quarter financial statement from the Form 10-Q published in August, 2001. Although the 2001 Annual Report Form 10-K would not have been published for a few more months, it provides more detailed information, much of which would have been available at the time, if not in the previous year’s 10-K. In this report the company discusses business conditions.
During this recession, new vehicles sales in the US had declined by 1% in 2000 and by another 1% in 2001, with a concomitant impact on OEM parts such as Tenneco’s shocks and exhaust systems. This may not sound like a severe downturn. However, the company’s business was quite marginal, generating an EBIT margin of only 5% in 2000 and 4% in 2001. As a manufacturer, it had high fixed costs associated with operating its plants, and a fully unionised workforce. As such, it had a high degree of operating leverage, depending upon high capacity utilisation to achieve an adequate profit margin. Moreover, the company had a lot of debt. As of June 2001 it had $208 million in short-term debt, and $1,382 in long-term debt, for a total of $1,590 in indebtedness. Interest rates were high, at least by today’s standards. The company’s weighted average interest rate was 12.7% in 2000 and 10.3% in 2001.
As of 31 December 2001, Tenneco had the following debt obligations.
Senior Credit Facilities:
The senior secured credit facility, as amended on March 13, 2002, consists of: (i) a $450 million revolving credit facility with a final maturity date of November 4, 2005; (ii) a $361 million term loan with a final maturity date of November 4, 2005; (iii) a $269 million term loan with a final maturity date of November 4, 2007; and (iv) a $269 million term loan with a final maturity date of May 4, 2008. Quarterly principal repayment installments on each term loan began October 1, 2001. Borrowings under the facility bear interest at an annual rate equal to, at our option, either (i) the London Interbank Offering Rate plus a margin of 350 basis points for the revolving credit facility and the term loan maturing November 4, 2005, 400 basis points for the term loan maturing November 4, 2007 and 425 basis points for the term loan maturing May 4, 2008; or (ii) a rate consisting of the greater of the JP Morgan Chase prime rate or the Federal Funds rate plus 75 basis points, plus a margin of 250 basis points for the revolving credit facility and the term loan maturing November 4, 2005, 300 basis points for the term loan maturing November 4, 2007 and 325 basis points for the term loan maturing May 4, 2008. Under the provisions of the senior credit facility agreement, the interest margins for borrowings under the revolving credit facility and the term loan maturing November 4, 2005 may be adjusted based on the consolidated leverage ratio (consolidated indebtedness divided by consolidated EBITDA as defined in the senior credit facility agreement) measured at the end of each quarter. Our senior secured credit facility does not contain any terms that could accelerate the payment of the facility as a result of a credit rating agency downgrade.
The senior secured bank debt had the following covenants, where,
Leverage Ratio = Total Debt / EBITDA
Interest Coverage Ratio = EBITDA / Interest Expense
Fixed Charge Coverage Ratio = Earnings / Fixed Charges
Leverage Ratio.......................... 5.50
Interest Coverage Ratio................. 1.55
Fixed Charge Coverage Ratio............. 0.80
The actual ratios in 2001 were as follows:
Leverage Ratio.......................... 6.26
Interest Coverage Ratio................. 1.42
Fixed Charge Coverage Ratio............. 0.55
Two of three covenants were breached, and the Interest Coverage Ratio was close to breach of the amended covenant as of year-end 2001. In fact, the senior secured credit facility was renegotiated thrice between 2000 and 2002, each time for a relaxation of covenants, in exchange for higher interest rates, fees, and certain restrictions.
The company also had a revolving credit facility, as well as subordinated debentures.
Revolving Credit Facility
Tenneco had a $500 million revolving credit facility. At the end of 2001 it had $371 million undrawn under its revolver. The capacity of the revolver was reduced by $50 million in March 2002; in spite of this, there was still ample liquidity. However, any further draws would have increased interest expense commensurably, and so had a negative impact on interest cover and overall financial position.
Our outstanding debt also includes $500 million of 11 5/8 percent Senior Subordinated Notes due 2009. The senior subordinated debt indenture requires that we, as a condition to incurring certain types of indebtedness not otherwise permitted, initially maintain an interest coverage ratio of not less than 2.25. The indenture also contains restrictions on our operations, including limitations on: (1) incurring additional indebtedness or liens; (2) dividends; (3) distributions and stock repurchases; (4) investments; and (5) mergers and consolidations. All of our existing and future material domestic wholly owned subsidiaries fully and unconditionally guarantee these notes on a joint and several basis. There are no significant restrictions on the ability of the subsidiaries that have guaranteed these notes to make distributions to us.
Munger said that he bought the junk bonds, which paid 11 3/8%. Upon inspection of the capital stack, I can only conclude that he slightly misspoke or misremembered the interest rate, and the above debentures were the ones he owned.
During the recession of 2000-2002, Tenneco took a series of steps to buttress its financial position.
Following the spin-off of the company’s shipbuilding, energy, and packaging businesses, from 2000-2002, Tenneco continued to rationalise its automotive parts manufacturing operations. In underwent several restructurings, closing numerous plants, and laying off 5% of its workforce.
In the fourth quarter of 2000, our Board of Directors approved a restructuring plan to further reduce administrative and operational overhead costs. We recorded, in the fourth quarter of 2000, a pre-tax charge related to the plan of $46 million, $32 million after tax, or $.92 per diluted common share. Within the statement of income, $13 million of the pre-tax charge is reflected in cost of sales, while $33 million is included in selling, general, and administrative expenses. The charge is comprised of $24 million of severance and related costs for salaried employment reductions worldwide and $22 million for the reduction of manufacturing and distribution capacity in response to long-term market trends. The 2000 plan involved closing a North American aftermarket exhaust distribution facility and a ride control manufacturing plant in our Asian market, as well as the consolidation of some exhaust manufacturing facilities in Europe. In addition, the plan involves the elimination of 700 positions, including temporary employees. We wrote down the assets at the locations to be closed to their estimated fair value, less costs to sell. We estimated the market value of buildings using external real estate appraisals. As a result of the single purpose nature of the machinery and equipment to be disposed of, fair value was estimated to be scrap value less costs to dispose in most cases. We do not expect that cash proceeds on the sale of these assets will be significant. As of December 31, 2001, 600 employees have been terminated under the 2000 plan primarily in North America and Europe. Additionally, 57 temporary employees have been terminated. All restructuring actions are being completed in accordance with our established plan. We expect to complete all restructuring activities related to this plan by the end of the first quarter of 2002. We are conducting all workforce reductions in compliance with all legal and contractual requirements including obligations to consult with worker committees, union representatives and others.
Restructuring costs were significant: $65 million in 2000, and $55 million in 2001.
Tenneco had paid a quarterly dividend of $0.05 per share in each quarter of 2000, but the dividend was suspended in 2001 due to the company’s losses, deteriorating financial position, and uncertain economic times. The company did not reinstate its dividend until 2017, upon which time it paid a $0.25 per share quarterly dividend for nine consecutive quarters, before suspending it again in the second quarter of 2019.
Tenneco was required to factor its receivables through an “accounts receivable securitization program” in order to maintain good standing with its creditors.
In addition to our senior credit facility and senior subordinated notes, we also sell some of our accounts receivables off-balance sheet on a periodic basis. In North America, we have a $100 million accounts receivable securitization program with a commercial bank. We sell original equipment and aftermarket receivables on a daily basis under this program. At the end of 2001, we had sold $68 million of accounts receivable under this program. This program is subject to cancellation prior to its maturity date if we were to (i) fail to pay interest or principal payments on an amount of indebtedness exceeding $50 million, (ii) default on the financial covenant ratios under the senior credit facility, or (iii) fail to maintain certain financial ratios in connection with the accounts receivable securitization program. This program carries a one-year renewable term ending in October of 2002. We previously renewed the program in October 2001. We also sell some receivables in our European operations to regional banks in Europe. At December 31, 2001, we had sold $42 million of accounts receivable in Europe. The arrangements to sell receivables in Europe are not committed and can be cancelled at any time. If we were not able to sell receivables under either the North American or European securitization programs, our borrowings under our revolving credit agreement would increase.
Sale and Leaseback
In negotiations with its creditors, Tenneco arranged to be allowed to engage in sale-and-leaseback transactions of some of its assets. (These subsequently remained unused.)
In March 2001, we amended our senior credit facility to revise the financial covenant ratios for 2001 and make certain other changes. As planned at the time of the March 2001 amendment, we again amended the senior credit agreement in March 2002. That amendment, among other things, revised the financial covenant ratios for 2002 through 2004, excluded from the calculation of our financial covenant ratios up to $60 million (before taxes) of charges and expenses related to cost reduction initiatives and allows us to enter into sale and leaseback transactions covering up to $200 million of our assets with the proceeds used to reduce senior debt and allowed us to exchange certain debt securities for common equity (to the extent we determine to pursue such actions in the future).
Note also the language about allowing them to “exchange certain debt securities for common equity”. This indicates that at this moment, Charlie’s debentures did not rank much higher than the common equity stub, and were at risk of being equitised.
For the three years prior to the investment, and those during the investment, Earnings before Interest and Tax (EBIT), in million USD, were as follows.
Earnings before Interest and Tax:
The average EBIT for these 7 years was $158 million. Since in most years, and on average, the amounts of depreciation and capex are similar, EBIT also approximates unlevered pre-tax free cash flow. At prevailing statutory tax rates of 35%, this would have equated to $103 million unlevered after-tax net income. For similar reasons, this would approximate unlevered free cash flow.
It should be noted that this EBIT is calculated after restructuring charges. However, the company incurred restructuring charges in every one of the above years, and in all but two years, these were in the tens of millions of dollars. So these ought to be considered recurring expenses, and not excluded from the calculation of unlevered earnings.
As of December 2001, immediately after the time of investment, Tenneco’s financial statements read as follows:
The company had positive working capital, but apparently no excess capital, and significant debt. Furthermore, at December 2001, it indicated the following long-term assets:
The machinery would have been of a single-purpose nature, and so could only be valued on a going-concern basis. As to whether there were any hidden assets such as large landholdings or real estate, it is not clear. Book value at cost less depreciation was $348 million, which is overall insignificant, but possibly understated for the land. The 10-K does not discuss any such landholdings or other non-core assets. Note also that the balance sheet indicates only $74 million in shareholders’ equity, including $441 million in goodwill and intangibles; hence negative tangible equity. As such, we have taken a going-concern approach to valuing the business.
As of December 2001, Tenneco’s debt stack looked as follows (figures in million USD).
Senior long-term notes—899
Subordinated long-term debt—500
Total interest-baring liabilities—1,606
Capital Structure and Enterprise Value
Given that the debentures traded at 35 cents on the dollar, the market value of the debt was less than the face value. As such, we make adjustment for the discounted paper based on Munger’s stated purchase price. We also calculate the market cap at the low share price, and the associated enterprise values. (Amounts in million USD, except per-share values.)
Total interest-bearing liabilities—1,606
Market value of interest-bearing liabilities—1,281
Cash and cash equivalents—53
Net debt at market—1,228
Cash and cash equivalents—53
Fully diluted shares outstanding—38,001,248
Share price, 17-18 October 2001—$1.35
Market capitalisation, fully diluted—51
Enterprise value at market—1,279
We calculate the enterprise multiple, EV/EBIT, based on 2001 EBIT, as well as the average of EBIT for the seven years 1998-2004, centred at 2001, and the theoretical unlevered after tax net income, each based on both the face value and the market value of the enterprise.
Face value of enterprise:
Market value of enterprise:
The first half of the 7-year period above was known at the time of Munger’s initial investment. While the EBIT from the second half, 2001-2004 would not have been knowable at the time of initial investment, it does not differ significantly. It is not particularly surprising, given the business fundamentals described in the financial reports around 2001, and gives some indication of what an analyst might have expected in the coming years.
The idea here is that if the senior debt could have been bought outright at face value—which seems likely, given that credit quality had deteriorated, and creditors would have wished to avoid any further impairments during the recession—then, assuming the bonds traded at the low price quoted by Munger, the entire enterprise could be purchased, at the low tick, for $1.28 billion. Unlevered, at statutory tax rates of 35%, it would have generated an average of $103 million. This implies a normalised, unlevered P/E of 12.5, and an earnings yield of 8%. Given that Tenneco’s weighted average cost of the company’s interest-bearing liabilities was more than 10% in 2001, at that time, the equity did not benefit from gearing. The Federal Reserve cut interest rates during the recession. 1-month LIBOR was as follows:
So, as the economy recovered from recession, Tenneco benefitted from gearing, and was able to refinance its debt. It also benefitted from increased revenues and cash flows from operations.
Tenneco’s Subsequent Financial Results
We performed a regression analysis on 20 years of the company’s accounts: from 1998, the earliest available (restated) breakout of the independent automotive parts business, to 2017, the year before a large acquisition, of Federal-Mogul. The findings, annualised, were as follows:
Share float growth—2.1%
Revenue growth, adjusted per share—4.1%
EBIT growth, adjusted per-share—5.8%
*Revenue c.a.g.r. was found from exponential regression.
**Because of the operating leverage inherent in the business, and the cyclical nature of the industry, the methodology was to build a linear regression model for the EBIT margin. The result was that the model values for EBIT margin rose from 3.9% in 1998 to 5.3% in 2017, for a roughly 1.6% c.a.g.r. in operating profitability. Then the (linear regressed) model value for EBIT margin was applied to the (exponentially regressed) model value for revenue.
In simple terms, it was found that the top line grew 6.3% per annum, but was diluted 2.1% by share issuance, to a revenue-per-share c.a.g.r. of 4.1%. But the business did become more profitable, on an enterprise basis, by 1.6% per year, during this two decade period. Hence the model output a smoothed EBIT-per-share, which was found to grow at 5.8% per annum. Because interest rates declined, even with a constant capital structure, the (levered) equity would have grown profit at a higher rate still. Of course, none of this was knowable at the time of investment in 2001. In particular, the interest rate trend may not have been foreseen. However, it is not that surprising that an automotive part supplier with large market share, being an established company in a mature industry, with the benefit of global operations, would grow at roughly the rate of nominal GDP (7%) and would sustain its low level of profitability. What was interesting was that profitability increased slightly. The reason for this is not immediately obvious. On the other hand, the R^2 value was low, at 0.07, so perhaps the trend is not statistically significant, but, rather, owes chiefly to the timing of economic expansion and contraction.
The purpose of the above investigation was partly out of interest to see how the business evolved, but also to reconcile actual business performance with intuition about how an investor might have thought about Tenneco’s prospects 20 years ago.
If one wished to calculate a theoretical IRR for the enterprise from 2001, one must note that the company retained all earnings until 2017, whereupon they made a large acquisition and reinstated a dividend. So one approach would be to tax a smoothed EBIT in 2017 (roughly $400 million) and hold it constant in perpetuity, assuming 100% payout and zero growth, capitalise this dividend at a discount rate, then discount it back to the enterprise value paid in 2001. The IRR would be roughly 8.5%. Allowing for dividend growth of 3% per annum with inflation, the IRR would be 10%. This could be considered an estimate of the firm’s return on invested capital (ROIC) from the initial purchase price, as determined by business performance and initial valuation. Since the company’s borrowing cost was lower than this ROIC for most of the period in question, the return on equity would be higher still. Dilution would be accounted for in the EBIT figure, but in practice, the Black-Scholes model does not perfectly account for the cost of dilution, so equity compensation could be added back to EBIT and then the IRR could be diluted by float growth. At any rate, the ultimate return on the enterprise from 2001 appears to have been in the 8-10% range. This is an adequate equity return, resulting from buying a mediocre business at a bargain price. The return flowed mostly to the levered equity and discounted debentures.
Although the company was able to refinance its debt at lower interest rates in 2004, and paid down some debt, it remained a highly-geared entity. Despite the share price rising to over $35 in 2011, and to over $70 in 2017, solvency concerns and market liquidity during the recessions of 2008 and 2020 took the stock back down to the $1 range in both years, just as they did in 2001.
Despite the significant gains Munger achieved, the enterprise valuation at the time of sale in 2004 was not much higher than in 2001. Net debt, at face value, fell from $1,553 in 2001 to $1,206 in 2004. EBIT rose from $92 million in 2001 to $174 million in 2004. Using EBIT after statutory tax for 2004, and also for the average of 7 years centred on 2004, we find:
Another way to look at the return on investment was that enterprise valuation increased by 24%, from 12.5x to 15.5x, the business grew modestly, and all the benefit of the growth and revaluation accrued to the equity stub of minuscule $51 million market cap, and to the debentures, which revalued from the distressed price of 35. Once insolvency was off the table, as seen by improving financial covenant ratios of leverage, interest cover, and fixed charges, and also from the refinancing at lower rates and terming out of debt, the business could be revalued, and the value accretion fell to the bottom of the capital stack. Essentially, the high return on investment came as a result of financial leverage from distressed valuation.
The Last Puff
The debentures were called at 105.8 in November 2004, and redeemed in December. Also at this time, the stock traded around the level of Charlie’s noted sale price of $15. Assuming Charlie Munger was redeemed and sold the shares at the same time, he realised a 300% return on the debentures, and a 1000% return on the stock, assuming he bought it at the low tick. He recalled a $1 purchase price, so it may have been closer to $1 than $2. Based on his report that he “made $80 million” on a $10 million investment, the imputed weighting of his investment between credit and equity would have been roughly 30% debentures and 70% stock. Based on these assumptions, his pre-tax IRR would have been 102%.
It is worth noting that Munger’s weighting in the two securities may not have been his optimal allocation. Because he deployed $10 million altogether, and the market cap at the low tick was roughly $51 million, it is unlikely he would have been able to buy only stock. Acquiring 20% of the shares outstanding would be difficult at the time of investment, for a couple of reasons. One was liquidity constraints: only roughly 10 million shares were transacted below $2, and significant buying pressure would have raised the offer prices. Another was reporting requirements: Munger would have had to declare his shareholding as soon as he held a 5% position. A prominent investor such as he might tip off the market that he was onto a bargain purchase. As such, he may have purchased the debentures our of a wish to deploy more capital than he could in the shares. However, it is possible that he wished to hedge his bet with a lower-risk security, higher in the capital stack.
Clearly if the company remained solvent, the upside was enormous. Even if he received the coupons and was repaid the principal, the return on the notes would have been quite satisfactory. If the debentures were not called, but redeemed at par, upon maturity in 2009, the IRR would be have been 43% on the debentures. Even if the equity expired worthless, he would still realise a 9% pre-tax IRR. So the risk to his overall exposure to the issuer was the risk of default. The senior creditors had $1.1 billion in claims which ranked prior to the sub debt. The senior secured facility had been restructured three times during the recession. So there was a reasonable possibility that if the recession had been deeper, and business conditions deteriorated further, that the company would have been forced into Chapter 11, and in the restructuring, the debentures would have been impaired. Indeed, they could have been worthless. Munger made a judgement about the economy and the business. He may have figured that the business, which, from a competitive standpoint, was not especially challenged, and expected that operations would eventually return to profitability, so that the banks, regarding the company as well managed, and realising that a liquidation of single-purpose assets would not yield any better recovery, would “extend and pretend” for as long as it took the economy to rebound. However, the interests of the debenture holders’ junior interest-bearing liabilities conflicted with the creditors’, so in theory, the banks could have caused the issuer to suspend the interest payments on Charlie’s junk bonds, or even forced the company into a restructuring, to protect their claims. Hence, the investment appears to have been not without risk. Certainly the equity was very cheap, essentially a stub, and had high option value. However, it also was certainly not without risk.
The unlevered EV multiple of 12.5 was reasonably inexpensive, but in view of Tenneco’s low profit margins and low growth, and the fact that interest rates were higher than today, with the 10-year note yielding between 4-5%, the enterprise value was not especially cheap. Altogether, the debentures were a distressed debt investment, a bet on solvency with a bargain price. The equity was essentially an option.
Given that Charlie characterised the investment as bearing “almost no risk”, I can only assume that he knew something I didn’t. It was a bargain purchase price, but, in view of economic conditions, industry fundamentals, and the company’s financial position, and because he held no claim on the senior credit, which was substantial, the investment seems to have lacked a true margin of safety. However, it was a good distressed equity investment, in risk assets at a bargain price. In view of this cursory analysis, not having observed and studied the situation in real time, as well as Munger’s superior investment acumen and record, I must give him full credit for a highly profitable investment. However, it is entirely possible that, being aware of this situation, an enterprising investor would have also been able to find other attractive opportunities, and might chosen to make other deep value investments, which were plentiful at that time of economic malaise.
The full interview may be found below. The discussion of Tenneco is contained in minutes 37:00—40:00.