Even though I dont think you should put your money strictly on macro views without a bottom up analysis of an asset, it is essential to understand the marco picture to assess what scenarios may adversly effect your poisitons and what global events may create value in certain industries or geographies.
There is alot of systemic risk in the global economy given the number of black swans we have seen in the past several months. Currently the market is trading at just over 15x trailing EPS, which in and of itself is not a useful statistic. US corporate profit margins are over 13%, near their highest level in 30 years, and well above the 8.4% average. These margins were brought about by the massive deflation we saw during the great recession. Labour was slashed, the prices of raw goods were decimated, and corporations ceased large capex that would have brought about increased depreciation expense. Capitalism dictates that high margin businesses bring about competition, leading to lower margins in the future. Profit margins are one of the most mean reverting statistics in finance.
How about the other factors affecting margins? Recent events in Libya, QE2, and supply disruptions in Japan have all increased the cost of both raw and processed goods. Both CPI and PPI components are showing well above core comfort levels for policy makers, and with high unemployment the Fed is still unlikely to rein in its liquidity barrage. PPI alone was up 35-40% in the last 6 months. Labour is the only component that has stayed in a deflated state. Combine the continued weakness in the labour market with the "tax" of high oil prices and you have a recipe for weak aggregate household demand. David Rosenberg and others have demonstrated that such large increases in oil prices have always lead to slower economic growth. The reason is simple; oil creates a tax on commercial users and households, while producers such as OPEC tend to save their new-found surplus wealth knowing that price increases may be temporary.
These factors ultimately lead to margin compression, so if there is going to be positive returns on stocks there must be robust sales growth to offset margins and multiples must remain above their long term averages (as they are now) or even expand. John Mauldin points out that if margins revert to historical norms, the PE ratio would be close to 24 at today's prices. The extension for QE2 may be the impetus for multiple expansion given the near perfect correlation between the Fed's balance sheet and asset prices. A long bet on equities means you believe that sales growth will be strong enough to offset margin reversion and multiples will stay at elevated levels, likely through a liquidity induced QE3 program. Sales growth could very well surprise on corporate spending given record cash hoards and ramping capex post recession.
A more likely scenario is that QE2 expires and the effects are observed. Margins compress due to oil price and supply disruptions emanating from Japan, while aggregate household demand feels the pinch of deflated wages and higher commodity prices. The remaining black swans out there are one of the PIIGS biting the bullet and the credit tightening that would ensue, or further oil disruptions stemming from the middle east. The world sure is a scary place, and its often the best time to invest when chaos and confusion rein. However, that is only the case if you are paying the right price for a specific asset, so if I were viewing the market as an asset I would not be going head long into it now.
Warren Buffet has been quoted recently saying that stocks are a screaming buy for those with a 10 year time horizon and deals exist. I certainly agree that specific assets are worth investing in when times get tough. Look at INTC, MSFT, or ORCL. These companies generate boat loads of cash and have considerable brand recognition and competitive advantages. Buffet's recent purchase of Lubrizol still gave him a 10% FCF yield in a company with massive market share. No one in the US wants to start a specialty chemical company anymore, even if they could! I think that the bulls, especially the smart ones like Mr. Buffet, should not make such broad blanket statements like rush out and buy stocks on margin, especially given the short term headwinds. Pick the names you like and the prices you want, and use the upcoming volatility as a buying opportunity.
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Tuesday, March 22, 2011
Sunday, March 20, 2011
European Goldfields
European Goldfields is a precious metals company with properties in Greece and Romania, with proven and probable reserves of 10mm oz of gold and 18mm oz of gold equivalent. The company generates cash flow from its 95% owned Stratoni operation, a high grade lead/zinc/silver mine in Northern Greece. The real reason to own EGU however is that the company is set to evolve into Europe's largest precious metals producer once the company obtains its final environmental approval and construction permits from the Greek and Romanian national governments. Having already obtained financing for mine construction, EGU could be producing 400k oz per year by 2013 at the lowest quartile cash cost in the industry with zero hedging in place.
The company has said that the Greek permits are imminent Q1/2011, although on Feb 24 Environment Minister Tina Birbili was mis-quoted by Reuters as saying that there needs to be more public consultation over the mines. Separately, the European Commission said that a 2003 sale of the mines by the Greek government was made for less than real value. After investigation they ruled that EGU would have a $21mm liability related to the sale. As for the first concern, the company is unaware of any delays in the permitting process and the translation from Greek to English was a problem with the Reuters article. Regarding the second, strategic holder Ellaktor will appeal the court ruling, although it will not likely make a difference given EGU's $2.17B market cap.
As Michael Lewis noted in Vanity Fair, Greece is an oddball place to do business. Rampant corruption, tax evasion, bribery, and a government that is essentially bankrupt all add to political risk. Luckily, EGU has a key strategic partnership with Ellaktor, a leader in southern European construction and one of the largest employers in Greece. Ellaktor holds 19.3% of EGU as a long term strategic holding. Given the country's high unemployment, precarious financial position, and strategic holders in the project the likelihood of approval is increased.
Based on conservative gold and base metal assumptions, EGU has a NAV in the $20+ range should the company receive approvals. Under a worst case scenario all approvals fall through and the company's vast proven reserves are given no value, the company is worth the value of its Stratoni mine, maybe a buck or less. Under a best case scenario the company receives approvals and has exploration success much like its recent high grade results at Piavitsa. The company will trade at NAV or a slight discount to NAV until Olympias reaches production. EGU management still guides that Greek approval is imminent, so a re-rating from the current $11.81/sh to the $18-$20 range in the next 3-6 months is not out of the question depending on what multiple the market wants to assign. As a vote of confidence insiders bought 60,000 shares on March 16th.
The Canadian options market is horribly illiquid, so it may take some time to buy calls and they wont be terribly cheap. I like buying calls because in a worst case scenario the EGU could fall considerably, but should the more likely outcome occur (permitting) a long call strategy provides a better risk/return. The July 15 calls went out at 0.65, Greek permitting should be in hand by then and Certej in Romania should be through its public consultation period.
The company has said that the Greek permits are imminent Q1/2011, although on Feb 24 Environment Minister Tina Birbili was mis-quoted by Reuters as saying that there needs to be more public consultation over the mines. Separately, the European Commission said that a 2003 sale of the mines by the Greek government was made for less than real value. After investigation they ruled that EGU would have a $21mm liability related to the sale. As for the first concern, the company is unaware of any delays in the permitting process and the translation from Greek to English was a problem with the Reuters article. Regarding the second, strategic holder Ellaktor will appeal the court ruling, although it will not likely make a difference given EGU's $2.17B market cap.
As Michael Lewis noted in Vanity Fair, Greece is an oddball place to do business. Rampant corruption, tax evasion, bribery, and a government that is essentially bankrupt all add to political risk. Luckily, EGU has a key strategic partnership with Ellaktor, a leader in southern European construction and one of the largest employers in Greece. Ellaktor holds 19.3% of EGU as a long term strategic holding. Given the country's high unemployment, precarious financial position, and strategic holders in the project the likelihood of approval is increased.
Based on conservative gold and base metal assumptions, EGU has a NAV in the $20+ range should the company receive approvals. Under a worst case scenario all approvals fall through and the company's vast proven reserves are given no value, the company is worth the value of its Stratoni mine, maybe a buck or less. Under a best case scenario the company receives approvals and has exploration success much like its recent high grade results at Piavitsa. The company will trade at NAV or a slight discount to NAV until Olympias reaches production. EGU management still guides that Greek approval is imminent, so a re-rating from the current $11.81/sh to the $18-$20 range in the next 3-6 months is not out of the question depending on what multiple the market wants to assign. As a vote of confidence insiders bought 60,000 shares on March 16th.
The Canadian options market is horribly illiquid, so it may take some time to buy calls and they wont be terribly cheap. I like buying calls because in a worst case scenario the EGU could fall considerably, but should the more likely outcome occur (permitting) a long call strategy provides a better risk/return. The July 15 calls went out at 0.65, Greek permitting should be in hand by then and Certej in Romania should be through its public consultation period.
Sunday, March 6, 2011
EGI Financial (8.10 last)
EGI is Canada's second largest (next to Westaim) non-standard auto and niche insurance company with direct written premiums of $185mm. Initially founded in 1997 as a insurance and reinsurance broker, EGI began focusing on underwriting opportunities not served by larger, standard insurers. In March 2010 EGI acquired American Colonial Insurance Company, a Florida based P&C insurer to expand in the US non-standard auto market. Presently EGI's revenue mix is 71% personal lines, with 72% of gross written premiums in the province of Ontario.
EGI's history shows a management team who has been successful at creating value for shareholders. According to a 2005 article in the National Post, "Douglas McIntyre is EGI's chief executive. In an earlier career, McIntyre was CEO of Pafco Insurance which, following a reverse takeover, became Pembridge Insurance Co. In 1998 that company was acquired by Allstate Insurance for about $400-million. Pafco was also a non-standard provider of automotive insurance. (Indeed, many of EGI's current management team worked with McIntyre at Pembridge.) That deal was a also a huge win for GTL, a Toronto-based merchant bank, which grossed $60-million from the sale. (LARR Capital, which originally stood for Little Abitibi River Resources, was the shell company used to take Pembridge public.) Paul Little, one of the three principals at GTL, is the chairman of EGI." It is also worth mentioning that management holds over 11% of the stock.
The first nine months of 2010 were rough for EGI, realizing combined ratios as high as 126% stemming from large claims in the Greater Toronto Area (GTA). Starting September 2010, Ontario's auto reforms were implemented to reduce claims costs on insurers. EGI also began reducing its exposure to the GTA by implementing a 10% rate increase, terminating selected broker relationships and decreasing commissions, tightening underwriting guidelines, and introducing a maximum 6-month policy term. The result was a significantly better 95% combined ratio. Niche lines had a 79.4% combined versus 142% in Q4/2009 as it exited unprofitable programs and tightened underwriting standards. For 2010 as a whole, Net Premiums Earned increased 13% to $162mm, showing strong market gains and a hardening price environment.
Although a strong Q4/2010 does not make a trend after 4 very disappointing quarters, EGI is poised to outperform. EGI is trading at only 67% of its current $12.14 book value per share. The two analysts on the stock have $0.65 of operating EPS based entirely on investment income. Should management's operating improvements carry through into 2011 we will see an underwriting profit and solid earnings leverage. Management is targeting a 95% combined ratio and 4% long term return on assets, equating to a 12% after-tax Return on Capital. If they can hit those metrics they can easily trade at book value. If they break even on underwriting they can still obtain an 8% ROE. I believe the current price is extrapolating the previous 4 quarters of horrendous underwriting losses into the future. The core business has improved, and with basically no debt or intangibles the balance sheet is free to take on leverage and expand. The shares are trading near the lowest P/B ever, close to levels seen in the 2008 crash. The shares are discounting a horrendous environment, best case scenario management hits their goals and we get a 50% pop over the next 12-24 months to trade in line with its book value.
EGI's history shows a management team who has been successful at creating value for shareholders. According to a 2005 article in the National Post, "Douglas McIntyre is EGI's chief executive. In an earlier career, McIntyre was CEO of Pafco Insurance which, following a reverse takeover, became Pembridge Insurance Co. In 1998 that company was acquired by Allstate Insurance for about $400-million. Pafco was also a non-standard provider of automotive insurance. (Indeed, many of EGI's current management team worked with McIntyre at Pembridge.) That deal was a also a huge win for GTL, a Toronto-based merchant bank, which grossed $60-million from the sale. (LARR Capital, which originally stood for Little Abitibi River Resources, was the shell company used to take Pembridge public.) Paul Little, one of the three principals at GTL, is the chairman of EGI." It is also worth mentioning that management holds over 11% of the stock.
The first nine months of 2010 were rough for EGI, realizing combined ratios as high as 126% stemming from large claims in the Greater Toronto Area (GTA). Starting September 2010, Ontario's auto reforms were implemented to reduce claims costs on insurers. EGI also began reducing its exposure to the GTA by implementing a 10% rate increase, terminating selected broker relationships and decreasing commissions, tightening underwriting guidelines, and introducing a maximum 6-month policy term. The result was a significantly better 95% combined ratio. Niche lines had a 79.4% combined versus 142% in Q4/2009 as it exited unprofitable programs and tightened underwriting standards. For 2010 as a whole, Net Premiums Earned increased 13% to $162mm, showing strong market gains and a hardening price environment.
Although a strong Q4/2010 does not make a trend after 4 very disappointing quarters, EGI is poised to outperform. EGI is trading at only 67% of its current $12.14 book value per share. The two analysts on the stock have $0.65 of operating EPS based entirely on investment income. Should management's operating improvements carry through into 2011 we will see an underwriting profit and solid earnings leverage. Management is targeting a 95% combined ratio and 4% long term return on assets, equating to a 12% after-tax Return on Capital. If they can hit those metrics they can easily trade at book value. If they break even on underwriting they can still obtain an 8% ROE. I believe the current price is extrapolating the previous 4 quarters of horrendous underwriting losses into the future. The core business has improved, and with basically no debt or intangibles the balance sheet is free to take on leverage and expand. The shares are trading near the lowest P/B ever, close to levels seen in the 2008 crash. The shares are discounting a horrendous environment, best case scenario management hits their goals and we get a 50% pop over the next 12-24 months to trade in line with its book value.
Friday, March 4, 2011
Danier Leather (12.33 last)
Danier Leather is a vertically integrated retailer that designs, manufactures and retails leather and suede products. Danier's coats, jackets, handbags, gloves, belts, and multitude of other products are available at their that 91 shopping mall, street front and "power center" locations across Canada. Danier currently has a pristine balance sheet with $43mm working capital with virtually no debt, a tangible book value of $61mm, and a market cap of $58mm. The company is well in the black, trading at only 8x trailing PE. Its these discount valuation metrics and Danier's competitive position that makes the stock attractive
Initially founded in 1972 as a manufacturer for direct sale to Canadian department stores, the company opened its first retail "Danier" location in Toronto in 1981. The strategy has been to primarily target the 35 to 55 year old middle to upper middle income female customers who seek quality garments and accessories at reasonable prices. The company has good relations with suppliers, sourcing animal "skins" from Europe and Asia at economical prices given the high volume of purchases. 92% of Danier's manufacturing is performed in Asia under supervision of Danier personnel, with the balance in Canada. This mitigates the strength of the Canadian dollar on COGS as these purchases are denominated in USD. Design, distribution and some manufacturing is done at a fully owned 130,000 square foot facility in Toronto. Danier's other distribution facility and retail locations are under lease.
During the economic crisis the shares hit panic stricken levels at 2.20/share. This was 0.2x book value! the shares have been a five and a half bagger since then, but even now the shares barely reflect the replacement cost of assets, let alone Danier's franchise value as the most recognized leather product company in Canada. Sales metrics are volatile, in 2010 same store sales were up 4%, although in the first two quarters of F2011 same store sales decreased 6%. Part of this stems from CEO Jeffrey Wortman's focus on higher margins instead of volume. Gross margins hit a record 58% in the most recent quarter. Overall floor space has shrunk as the company focuses more on mall locations versus outlets. Less seasonal and economically sensitive accessories sales have jumped to 25% or sales from 4% in 1998, and were up 11% for the 27 week period ended Jan 1 2011. The company is also starting to target 20 to 35 year old customers with more fashion forward designs at popular price points. Sales per square foot has increased every year since 2006.
The Wortman family owns all 1.22mm multiple voting shares and Danier has been aggressively buying back stock. In a dutch auction in March/April of 2010 the company bought back 1.12mm shares @ $6.25. Of the 4.7mm shares, 1.22mm are multiple voting held by the Wortman family, leaving 3.48mm subordinate voting shares outstanding. According to Bloomberg 6 institutions (mostly value funds) hold 2.86mm shares. This means 620k shares are in retail and other accounts, which partially explains why the stock's ADV is 8,800 shares. There are very few holders to convince in a buyout, and leverage could certainly be used given the businesses strong cash flow and clean balance sheet.
Risks to Danier's investment thesis include the cost of leather, which has competitive usage in shoes, furniture, car upholstery, as well as the cost of chemicals used in tanning. Emerging economies with higher incomes now compete for raw material. Also, China could reduce or eliminate its value added tax (VAT) export refund and could have an adverse effect of costs for Danier. Consumer debt levels in Canada are shockingly high and discretionary income is taking a hit from high commodity prices and still elevated unemployment levels. A slew of US retailers including Target, J Crew, Kohl's and several others are rumoured to be entering the Canadian retail space due to higher sales per square foot and lower retail square footage per capita vis a vis the US.
The first two concerns about cost are faced by virtually every retailer and are definitely something to be cognizant of. I admit that I do not have strong views on the leather market, although the strong CAD has mitigated USD based costs. Debt levels in Canada are high, but a stroll around the mall suggests that consumers are not hurting. Danier in particular has a steady flow of customers in a number of locations I visited, and family members love the accessories and jackets. The last point, that high sales per square foot is attracting competition is concerning, but Danier already has a foothold and if the company can improve operationally, as they have been over the last few quarters, then they have a compelling franchise value.
From a valuation perspective I do not see a massive ramp in same store sales or outlet expansion. Management's philosophy is to focus on profitability. Many Canadian retailers have realized greater than 10% operating margins versus Danier in the 5-6% range. With no significant Capex outlay in excess of depreciation and minimal need for increased working capital, Danier has huge free cash flow leverage to modest margin improvement. While the shares are unlikely to deliver another 5 bagger anytime soon, managements newfound commitment to profitability and clean balance sheet makes the shares look compelling at prevailing levels.
Initially founded in 1972 as a manufacturer for direct sale to Canadian department stores, the company opened its first retail "Danier" location in Toronto in 1981. The strategy has been to primarily target the 35 to 55 year old middle to upper middle income female customers who seek quality garments and accessories at reasonable prices. The company has good relations with suppliers, sourcing animal "skins" from Europe and Asia at economical prices given the high volume of purchases. 92% of Danier's manufacturing is performed in Asia under supervision of Danier personnel, with the balance in Canada. This mitigates the strength of the Canadian dollar on COGS as these purchases are denominated in USD. Design, distribution and some manufacturing is done at a fully owned 130,000 square foot facility in Toronto. Danier's other distribution facility and retail locations are under lease.
During the economic crisis the shares hit panic stricken levels at 2.20/share. This was 0.2x book value! the shares have been a five and a half bagger since then, but even now the shares barely reflect the replacement cost of assets, let alone Danier's franchise value as the most recognized leather product company in Canada. Sales metrics are volatile, in 2010 same store sales were up 4%, although in the first two quarters of F2011 same store sales decreased 6%. Part of this stems from CEO Jeffrey Wortman's focus on higher margins instead of volume. Gross margins hit a record 58% in the most recent quarter. Overall floor space has shrunk as the company focuses more on mall locations versus outlets. Less seasonal and economically sensitive accessories sales have jumped to 25% or sales from 4% in 1998, and were up 11% for the 27 week period ended Jan 1 2011. The company is also starting to target 20 to 35 year old customers with more fashion forward designs at popular price points. Sales per square foot has increased every year since 2006.
The Wortman family owns all 1.22mm multiple voting shares and Danier has been aggressively buying back stock. In a dutch auction in March/April of 2010 the company bought back 1.12mm shares @ $6.25. Of the 4.7mm shares, 1.22mm are multiple voting held by the Wortman family, leaving 3.48mm subordinate voting shares outstanding. According to Bloomberg 6 institutions (mostly value funds) hold 2.86mm shares. This means 620k shares are in retail and other accounts, which partially explains why the stock's ADV is 8,800 shares. There are very few holders to convince in a buyout, and leverage could certainly be used given the businesses strong cash flow and clean balance sheet.
Risks to Danier's investment thesis include the cost of leather, which has competitive usage in shoes, furniture, car upholstery, as well as the cost of chemicals used in tanning. Emerging economies with higher incomes now compete for raw material. Also, China could reduce or eliminate its value added tax (VAT) export refund and could have an adverse effect of costs for Danier. Consumer debt levels in Canada are shockingly high and discretionary income is taking a hit from high commodity prices and still elevated unemployment levels. A slew of US retailers including Target, J Crew, Kohl's and several others are rumoured to be entering the Canadian retail space due to higher sales per square foot and lower retail square footage per capita vis a vis the US.
The first two concerns about cost are faced by virtually every retailer and are definitely something to be cognizant of. I admit that I do not have strong views on the leather market, although the strong CAD has mitigated USD based costs. Debt levels in Canada are high, but a stroll around the mall suggests that consumers are not hurting. Danier in particular has a steady flow of customers in a number of locations I visited, and family members love the accessories and jackets. The last point, that high sales per square foot is attracting competition is concerning, but Danier already has a foothold and if the company can improve operationally, as they have been over the last few quarters, then they have a compelling franchise value.
From a valuation perspective I do not see a massive ramp in same store sales or outlet expansion. Management's philosophy is to focus on profitability. Many Canadian retailers have realized greater than 10% operating margins versus Danier in the 5-6% range. With no significant Capex outlay in excess of depreciation and minimal need for increased working capital, Danier has huge free cash flow leverage to modest margin improvement. While the shares are unlikely to deliver another 5 bagger anytime soon, managements newfound commitment to profitability and clean balance sheet makes the shares look compelling at prevailing levels.