Description
SUMMARY: Nothing like turning in your homework at the last minute. :-)
My investment idea is the 12.75% senior subordinate notes of Aavid Thermal Technologies (AATT – Cusip 002539AB0), which are due in February of 2007, and are currently trading around 73.
I am sure that you will agree with me that this investment sounds reasonable because AATT has the following characteristics (since I am sure someone will mention them if I don’t):
1. A large fraction of the company’s revenue is related to the robust electronics industry;
2. The company had the good fortune to undergo a well-timed leveraged buyout in February of 2000 at the bottom of the market;
3. The leveraged buyout included the merger of two commodity businesses that had many customers in common despite dual sourcing being the norm in the electronics hardware business;
4. The leverage ratio in the buyout was quite reasonable with ~$5 million in cash used to float ~$200 million in total debt;
5. The company has undergone many changes in management over the past six years;
6. The company’s ownership structure is not exactly crystal clear;
7. The manufacturing portion of the company has been restructured and downsized repeatedly over the past three years due to a large decrease in its revenues;
8. The company’s financial statements for the past few years are being reaudited because of a change in revenue recognition of a portion of the company and because they had to change auditors after the Arthur Anderson bankruptcy;
9. The debt of the company is rated Caa2 by Moody’s and the company was in violation of the financial covenants of its credit facility from October 2001 to August 2002; and
10. Finally, their SEC filings are a joy to read because it is obvious that the author has a degree from the Warren Buffett School of Writing Easy to Understand Financial Statements (I am being harsh, they are okay; they just take a lot of effort to understand because there is a lot to track).
Although those characteristics should already have you salivating over the prospect investing in the company’s debt, I feel that I should I provide more details about why I think this investment is reasonable.
Long story, short:
Aavid Thermal Technologies (AATT) is a privately held company that controls two companies: Fluent – a company that develops and markets computational fluid dynamics (CFD) software and Aavid Thermalloy (Aavid) – a global company that designs and manufactures products for the thermal management of electronics. Until it was sold a few months ago, AATT also owned Curamik, a manufacturer of direct bond copper substrates for the power semiconductor industry.
Both Aavid and Fluent are technology and market leaders in the respective areas. Fluent is the market leader with about 40% of the worldwide CFD market and it is clearly the technology leader. Aavid is the market leader in the merchant thermal management business for electronics with about 30% of the worldwide market and it is near, if not at the top, in terms of technology in this area. The previous statement was not true a few years ago, but Aavid’s technology capabilities have improved dramatically over the past four years.
The main equity owners of the company are Willis and Stein Partners, a private equity investment firm, and company insiders. This group acquired AATT in a leveraged buyout in February of 2000. In the SEC filings, this group is referred to as Heat Holdings. Willis and Stein Partners are the primary owners of the company although I believe they have significantly more control of Aavid than Fluent through an affiliate of Heat Holdings called Heat Holding II – there is more detail in the SEC filings.
The main holders of Aavid’s debt are Oaktree Capital and company insiders, who own the bulk of the senior subordinate notes, and two banks, which provide its credit facility.
I believe that these bonds are a better than average investment because:
1. In the current environment of the global electronics industry, AATT is being carried by Fluent – a great business – while Aavid is struggling to break even. After wading through the SEC filings (the details and joy of which I will leave to you), I believe that the owner earnings of Fluent (using Buffett’s definition) are about 25% to 30% of Fluent’s revenues (~$70 million in revenues and ~$19 million in owner earnings). This cash flow is more than enough to service AATT’s debt as long as Aavid does not lose too much money.
2. In case of default, Fluent is worth more than all of AATT’s debt. I expect that Fluent will grow somewhere between 10% and 20% for at least the next ten years with its owner earnings being equal to at least 25% of its revenues. I feel that it is that a good a business and is worth more than the $200 million in AATT’s total debt. Aavid also has some value and has a real chance of being of being worth than Fluent in a few years although it is hard to make this argument when it is currently struggling to break even.
3. Willis and Stein Partners face a large risk to their credibility if the bond holders of AATT lose money. They are a private equity investment fund that is just starting to invest $1.8 billion in its third fund (AATT was part of their second fund). Future leverage buyouts that utilize publicly traded debt will be more likely to occur if AATT bond holders who hold their bonds to maturity don’t lose money (this statement also applies to Ziff Davis bonds since it is another Willis and Stein investment). To bring the company back into compliance with financial covenants and meet commitments to bond holders, Willis and Stein added $34 million of equity to the investment last year, added another $12 million this year (although this investment seems to be structured more like a loan at 12%), and sold Curamik for over $30 million this year.
4. If you believe as I do that this investment has an adequate margin of safety, then the purchase price of 73 is reasonable because it implies a ~17% yield and ~24% yield to maturity.
Long story, longer but still trying to be short:
Warren Buffett has stated that an investor should try to determine if the aggregate after-tax receipts from an investment over the investment timeframe will result in at least as much purchasing power as today, plus a reasonable rate of return. To make this determination, the investor needs to evaluate:
1. the certainty of the economic characteristics of the investment;
2. the certainty with which management can be evaluated to act in investor interests;
3. the purchase price of the investment; and
4. the effect of taxation and inflation on the investor’s purchasing power.
I will use this framework to provide more detail on an investment in the senior subordinate notes of AATT.
Certainty of long-term economic characteristics:
Fluent has a high probability of growing between 10% and 20% annually for at least the next ten years (even if the economy is dreadful) with no change in economic characteristics because there is a growing demand for CFD software and Fluent possesses significant competitive advantages.
Although the market is much smaller, Fluent is a Microsoft equivalent in one area of the engineering world – modeling fluid flow, heat transfer, combustion, multi-phase systems etc. for a variety of problems/industries. CFD software is an incredible time saver in the design and modeling phase of engineering. Designs that used to take years (underhood design of car) or months (system design of an electronics chassis) have been reduced to months or weeks by using CFD. As computing power has become more affordable, CFD can be economically applied to a larger variety of problems. Fluent has taken advantage of this trend by tailoring “lightweight” versions of its full code to specific industries. Examples include Icepak (electronics cooling and thermal management) and Airpak (building air circulation/heating/air-conditioning). These “lightweight” codes actually run full Fluent but have front ends that make them able to be used efficiently and accurately by an engineer who is not an expert in CFD.
The main competitive advantages of Fluent are its workforce, its work-to-date, and the head start it has on its major competitors. AATT has about 200 PhD’s and 300 engineers. Almost all the PhD’s and most of the engineers work for Fluent. To put these numbers in perspective, these engineers represent about 5% of the world’s engineers in this area and Fluent engineers are among the best. The value of this resource should not be underestimated.
Fluent’s software codes – by luck or by design – are built on a solid foundation. Fluent’s CFD codes were the first to focus on and emphasize automatic mesh generation. After they had that down, Fluent worked on making their CFD codes more efficient and their models better. The order in which things were done gives them a huge advantage because they built a general purpose problem solver which they can easily adapt to other problems. Their competitors, who have more specialized solvers and mesh generators, have a much more difficult time trying to adapt their codes to a different type of problem than that for which they were designed. Solving the general problem first gives a Fluent a head start that they continue to push. In addition to creating codes for specific problems, they continue to expand their capability in solving the general problem (one example is adaptive meshing). What all this means is that it will take a large group of engineers a significant amount of time and money to catch to Fluent and that is not going to happen within the next five years.
The certainty of Aavid economic characteristics is far less predictable which is why I assign it a zero value in my margin of safety calculations. I can envision scenarios where Aavid is actually more valuable than Fluent within the next ten years and scenarios where Aavid is liquidated for its brand name and distribution business. The competitive environment of Aavid is changing dramatically, and I have no idea how the story will turn out.
Aavid is the dominant merchant provider of thermal management solutions to the electronics industry. Its business is broken up into three main components: a distribution business of standardized cooling solutions (mainly through catalogs and large distributors such as Arrow), a custom build-to-print business (e.g. industrial and military customers including traction drives, power semiconductors, radio frequency antennas etc.), and global hardware business cooling mainly microprocessors for OEMS in the computer, telecom, networking and server arenas.
If Aavid was not involved in the third business, I feel that the economic characteristics of Aavid would be predictable. The main competitors that Aavid has in the first two businesses are Wakefield Engineering and Thermacore (a division of Modine). Aavid is a better company that either of these companies by a large margin and its lead should only continue to grow. It has a large technology edge over Wakefield and a smaller technology and manufacturing edge over Thermacore. Margins are reasonable in these areas and these areas also have less of a boom/bust cycle.
However, in the third business area – the global hardware business for OEM’s – the competition is brutal, the environment is changing both for Aavid and for its customers, and the thermal problems (power dissipated in chips) have become difficult enough that new technologies are starting to be adopted. Touching slightly on each of these issues:
1. Brutal competition: Aavid’s main competitors include Foxconn (Hon Hai Precision), Furukawa, Fujikura, and Thermacore. The first three companies are quite strong and have different strengths and weakness when compared to Aavid. Margins are low in this business to begin with and have dropped further with the increased competition in this downturn.
2. Environment is changing: There are three main trends. The first trend is that captive thermal management business is being outsourced by many smaller companies and also by larger OEMS as the technology is changing and the solutions become harder to design. The second trend is that the customer base is changing and is increasingly being dominated by the bigger companies. The third trend is the influence of China makes predicting the future dominance of any company in the electronics business much harder. This statement even applies to a company like Dell, which most people view as a no-brainer. I feel that Dell will be seriously challenged by a newly announced Foxconn/Wal-mart combination (Foxconn which is the dominant Chinese thermal management company is going to make dirt cheap, fully capable computers in its Chinese facility and distribute them through Wal-mart; Foxconn is extremely aggressive and they will move up the chain fast).
3. The technology required for the thermal management of electronics is changing because the problem has become much harder with the higher powers and smaller sizes. Your old air cooled heat sink in your laptop or computer is probably going to have to be coupled to a liquid cooled device or a two phase device or exotic heat spreader.
Certainty with which management can be evaluated, both in ability to realize full potential of business and to allocate its cash flow wisely:
Management interests are aligned with the interests of the bond holders. Company insiders are significant owners of the bonds, and, as mentioned before, Willis and Stein Partners faces a risk to their credibility if their bond holders lose money.
As for the ability to realize the full potential of the business, the CEO of the company, Dr. Patel, is the founder of Fluent. He has a PhD in fluid dynamics and should understand the technical issues related to Fluent as well as anyone. He has been the CEO of Fluent since its inception. Your guess is as good as mine of whether he will get Aavid to realize its full potential. As for acting in the best interests of investors, as the revenues of Aavid have declined, he has downsized the company accordingly. I believe that Aavid will operate in a break even mode as a worst case scenario (even if it means shrinking the company).
Purchase Price:
If you believe as I do that this investment has an adequate margin of safety, the purchase price of 73 is reasonable because it implies a ~17% yield and ~24% yield to maturity. Truth in advertising, my purchase price for these bonds was ~40 (32% yield, 44% YTM) last winter. Self-interest precluded me from posting the idea because the bonds are fairly illiquid and it takes a few months to build a position.
The reason I mentioned the 40 price is to make sure that investors understand that this investment is one that they should be prepared to hold to maturity.
Effect of taxation and inflation on investor’s purchasing power return:
Taxation will not change the purchasing power return relative to other comparable investments.
Catalyst
There is no catalyst associated with this idea.