A good week
With the utmost humility I am quite pleased with how my picks have performed to date. On Monday Sun Gro Horticulture was the subject of a friendly takeover at 6.60, which I highlighted as a strong possibility when I recommended the story. Here is how my picks have panned out so far:
Sun Gro +50%
Westaim +21%
MB Bonds +1% (+accrued)
Imris +10%
I am fully aware that it is not normal to have all of ones securities go up, especially in a short amount of time. In my writings I mentioned how these were bound to work over a longer time period. I do not expect my next selections to perform this well off the hop, and some of these names (not the Sun Gro) could go down before I decide to sell. Actually, while purchasing these securities I kept some dry powder to buy them should they get cheaper. It worked in the case of Sun Gro, I was able to average down at $4, but the rest of them shot up. I suppose you cannot be too cute with these things. Anyways, I will certainly enjoy it while it lasts.
Going forward there will be several postings per week. There are alot of ideas that don't make the cut, either because I don't really understand what the company does (and do not have time to figure it out, since I work) or the margin of safety is not large enough. Correctly identifying that something does not work can often be just as helpful as identifying an idea that does from a personal development perspective. That being said, I will always sit on cash until another good idea comes along. You get paid for aggressively implementing a conservative approach, not through frequent activity.
Friday, January 21, 2011
Thursday, January 20, 2011
Musings on Investment Philosophy
I have spent a considerable amount of time thinking about how one should approach investing. While merely a memo and not a comprehensive essay, I hope to summarize my views in a quick but concise manor. I believe that an investor needs to get comfortable with what they are truly capable of knowing about the economy, assets within the economy, managements that determine the use of those assets, and securities that entitle holders to legal claims upon assets and cash flows. How much can you know about each of these topics, and how much do you need to know? What is more important, a grandiose top down view of where the world is headed or bottom up understanding of a business? Finally, and most importatly, how does this factor into the price you pay for a security?
Many market participants pontificate about what GDP growth will be, what Ben Bernanke will say in the next FOMC, when China will raise rates, what the forward PE
of the market is, and volumes of other data that investing professionals think is crucial to asset allocation. The truth is, any student of economic history knows that in aggregate people are horrible at forecasting the future of the economy. It has been shown by SocGen's Dylan Grice, Reinhart and Rogoff, and Nassim Taleb that asset price performance is highly nonlinear. There is a very simple reason for this: it is impossible to know the future! Even if you feel reasonably assured of the future, at least a range of possible outcomes, you will not realize a high return on your investment unless you pay a price for a security that ensures a high return. The price that ensures a rate of return whileminimizing downside risk is arrived at only through a bottom up analysis of a number of scenarios. The scenarios can be a number of company specific outcomes (i.e. will the company win a large new contract?) or macro outcomes (will oil be at $80 or $50?).
Purchasing a equity or debt security gives you legal claim on specific assets and cash flows associated with those assets. Although financial accounting is not perfect, audited financial statements and publically disclosed documentation give you
an assessment of asset value under a given set of assumptions. Historical financial statements also give you an idea of what cash flows the assets can generate under a variety of economic scenarios, if the asset base has not changed considerably. The problem is that consistent strong historical performance is easily recognized so the securities on such companies are often well picked over and fully valued on a risk reward basis.
It is critical that valuation is performed on an "a prioi" basis. Some of the best opportunities arise out of corporate events where 1) the asset base is completely different that prior reporting periods, and therefore has limited historical operating data (see my prior piece on Westaim's purchase of Jevco assets), or 2) claims on a companies assets have changed, either through recapitalization or emergence from bankruptcy (see Mega Brand bonds). There are a large number of other corporate actions that provide such opportunity, like spin outs, mergers, etc... Change is what creates opportunity, especially change that other investors feel is out of their expertise. Publically disclosed documents on corporate actions combined with good old fashioned scuttlebutt can give you an idea of what performance can be expected out of a new operating entity. This type of data is not uploaded into database that can be screened for valuation ratios or growth rates, so it is often not picked up by a large class of investors that use screens as a primary idea generation tool. Once the company releases several quarters of results the quants start to pick up on the story.
The best part of investing is that corporate actions don't necessarily have to be the focus of research or idea generation. Any time there is a structural reason for securities being bid up or sold off creates opportunity as well. Index rebalances, analyst initiations, financial duress of a large holder, or changes in foreign ownership laws are only a sample of events that change the dynamics of a market.
I suppose what I am really trying to say is that I usually have a blank look on my face when someone asks where the market is going. I have no idea. I also have no idea what the EPS of Wal Mart will be, or whether the PE multiple of Google will expand. I dont know the future, and I dont have to. As long as I can define the scope of my understanding about a specific situation and pay a price that warrants limited downside versus potential return, the rest will take care of itself.
Many market participants pontificate about what GDP growth will be, what Ben Bernanke will say in the next FOMC, when China will raise rates, what the forward PE
of the market is, and volumes of other data that investing professionals think is crucial to asset allocation. The truth is, any student of economic history knows that in aggregate people are horrible at forecasting the future of the economy. It has been shown by SocGen's Dylan Grice, Reinhart and Rogoff, and Nassim Taleb that asset price performance is highly nonlinear. There is a very simple reason for this: it is impossible to know the future! Even if you feel reasonably assured of the future, at least a range of possible outcomes, you will not realize a high return on your investment unless you pay a price for a security that ensures a high return. The price that ensures a rate of return whileminimizing downside risk is arrived at only through a bottom up analysis of a number of scenarios. The scenarios can be a number of company specific outcomes (i.e. will the company win a large new contract?) or macro outcomes (will oil be at $80 or $50?).
Purchasing a equity or debt security gives you legal claim on specific assets and cash flows associated with those assets. Although financial accounting is not perfect, audited financial statements and publically disclosed documentation give you
an assessment of asset value under a given set of assumptions. Historical financial statements also give you an idea of what cash flows the assets can generate under a variety of economic scenarios, if the asset base has not changed considerably. The problem is that consistent strong historical performance is easily recognized so the securities on such companies are often well picked over and fully valued on a risk reward basis.
It is critical that valuation is performed on an "a prioi" basis. Some of the best opportunities arise out of corporate events where 1) the asset base is completely different that prior reporting periods, and therefore has limited historical operating data (see my prior piece on Westaim's purchase of Jevco assets), or 2) claims on a companies assets have changed, either through recapitalization or emergence from bankruptcy (see Mega Brand bonds). There are a large number of other corporate actions that provide such opportunity, like spin outs, mergers, etc... Change is what creates opportunity, especially change that other investors feel is out of their expertise. Publically disclosed documents on corporate actions combined with good old fashioned scuttlebutt can give you an idea of what performance can be expected out of a new operating entity. This type of data is not uploaded into database that can be screened for valuation ratios or growth rates, so it is often not picked up by a large class of investors that use screens as a primary idea generation tool. Once the company releases several quarters of results the quants start to pick up on the story.
The best part of investing is that corporate actions don't necessarily have to be the focus of research or idea generation. Any time there is a structural reason for securities being bid up or sold off creates opportunity as well. Index rebalances, analyst initiations, financial duress of a large holder, or changes in foreign ownership laws are only a sample of events that change the dynamics of a market.
I suppose what I am really trying to say is that I usually have a blank look on my face when someone asks where the market is going. I have no idea. I also have no idea what the EPS of Wal Mart will be, or whether the PE multiple of Google will expand. I dont know the future, and I dont have to. As long as I can define the scope of my understanding about a specific situation and pay a price that warrants limited downside versus potential return, the rest will take care of itself.
Wednesday, January 19, 2011
Imris (7.25 last)
This is not my typical recommendation due to its high valuation on almost any forward or trailing metric. That being said. Imris could be a powerhouse growth story over the next 5 years due to an outstanding CEO, its widely acknowledged technological superiority, and current product penetration (less than 1%) in a massive market. Given that the stock trades at 3.5x book value and 4.5x sales, most "value" analysts would run from the story kicking and screaming. A more appropriate way of thinking about the story is looking at the existing management, the existing product, the successes to date, and the potential size of their end market.
Imris makes mobile Magnetic Resonance Imaging (MRI) platforms for hospitals and clinics that produce non-invasive images of soft tissue during complex surgical procedures. Since being founded in 2005, they have sold 41 of their systems worldwide. The flagship product, IMRISneuro (34 sold) has a $4mm-$7mm price tag and is used for neurosurgeries, primarily brain tumour removal. The second product, IMRISuv (3 sold) has a $7-$10mm price tag and combines MRI with real time x-ray images (flouroscopy). The third product (4 sold) called IMRIScardio sells for $8-$12mm and incorporates MRI and flouroscopy for cardiovascular applications such as the treatment of coronary artery disease. An interesting fourth product is a result of a joint venture between Imris and Varian Medical Systems can be expected in late 2011. The product will combine Imris's real time imaging with Varian's TrueBeam radiation therapy system. Its worth noting that Varian is a market leader, with a 60% market share in radiotherapy and radiosurgery accounting for $3.7B in annual sales and an install base of 6,000 units. The partnership is a strong vote of confidence in Imris's technology.
The key to Imris platforms is that the can be used for pre, intra, and post operating imagery. Existing platforms sold by GE, Siemens, and Philips are large and static. They require doctors to move the patient out of the operating room intra-operation, place the patient in an MRI machine, then bring the patient back to the operating room. During complicated and time-sensitive surgeries this movement is unacceptable. Imris's mobile MRI can be brought into the operating room on an installed track, image the patient without moving them, then be removed so that surgeons can get back to work. Hospitals like the Imris systems so much that Imris has a greater than 80% win rate in competitive bidding. Contract loses are not due to a deficiency in the product, but hospital budget issue as Imris systems cost more than their competitors.
One of the highlights of the story is CEO David Graves. Mr. Graves is a professional engineer and serial entrepreneur that started wireless telecommunications company Broadband Networks, which he sold to Nortel in 1998. From 1998 to 2005 he was CEO of venture capital company Centara Corp before starting Imris. Mr. Graves is the largest holder of Imris with 26.7%, while total insider ownership accounts for 35%. The management team is comprised of very technically astute individuals who have a reputation among clients for their knowledge and professionalism.
From a financial prospective, Imris estimates that the number of hospitals with expertise in neurosurgery is (the market for IMRISneuro) is 990 versus their current install base of 34. Wedbush estimates that there are 781 stroke centers in the US (IMRISnv) and 669 heart centers (IMRIScardio) that have high patient volumes and are experienced in handling complex cases. The total global market for each of their current three products, according to their research, could be nearly 5,200 centers. Compare this to the 41 systems they have sold since 2005. Regardless of what the total number of customers is, Imris is nowhere near reaching the limit. Sales of new units could easily double or triple, while they will also get recurring service and maintenance revenue from a widening install base. Sales backlog has grown 44% YoY to $120mm, of which at least 80% will be realized in the next 12 months.
The company may be trading at 2.3x 2011 EV/sales, but this is not Coke or Proctor and Gamble. Imris has a good shot at doubling their sales in the next 3 or 4 years. They have a strong management team with a big ownership of the business. There is no competitive threat as Imris has copyrights on their mobile technology until 2015. The downside risk is that Siemens supplies critical components in the Imris system, and are also a competitor. Sales are also choppy as single wins or losses greatly affect quarterly results when the company is small. Hospitals on mass could also cut budgets (unlikely as sales grew throughout 2008 and 2009) or regulatory approval for new products could be slower than usual. You risk selling down to a multiple of book (at which someone scoops the patents) or 1x sales, since thats how tech people like to look at it, say $3 on a complete fire sale. I view this as highly unlikely. You could lose 50% to make 2 or 3 times your money within 3 to 4 years. I view the bullish argument as a much higher probability given the competitive advantages and growth potential I mentioned above.
Imris makes mobile Magnetic Resonance Imaging (MRI) platforms for hospitals and clinics that produce non-invasive images of soft tissue during complex surgical procedures. Since being founded in 2005, they have sold 41 of their systems worldwide. The flagship product, IMRISneuro (34 sold) has a $4mm-$7mm price tag and is used for neurosurgeries, primarily brain tumour removal. The second product, IMRISuv (3 sold) has a $7-$10mm price tag and combines MRI with real time x-ray images (flouroscopy). The third product (4 sold) called IMRIScardio sells for $8-$12mm and incorporates MRI and flouroscopy for cardiovascular applications such as the treatment of coronary artery disease. An interesting fourth product is a result of a joint venture between Imris and Varian Medical Systems can be expected in late 2011. The product will combine Imris's real time imaging with Varian's TrueBeam radiation therapy system. Its worth noting that Varian is a market leader, with a 60% market share in radiotherapy and radiosurgery accounting for $3.7B in annual sales and an install base of 6,000 units. The partnership is a strong vote of confidence in Imris's technology.
The key to Imris platforms is that the can be used for pre, intra, and post operating imagery. Existing platforms sold by GE, Siemens, and Philips are large and static. They require doctors to move the patient out of the operating room intra-operation, place the patient in an MRI machine, then bring the patient back to the operating room. During complicated and time-sensitive surgeries this movement is unacceptable. Imris's mobile MRI can be brought into the operating room on an installed track, image the patient without moving them, then be removed so that surgeons can get back to work. Hospitals like the Imris systems so much that Imris has a greater than 80% win rate in competitive bidding. Contract loses are not due to a deficiency in the product, but hospital budget issue as Imris systems cost more than their competitors.
One of the highlights of the story is CEO David Graves. Mr. Graves is a professional engineer and serial entrepreneur that started wireless telecommunications company Broadband Networks, which he sold to Nortel in 1998. From 1998 to 2005 he was CEO of venture capital company Centara Corp before starting Imris. Mr. Graves is the largest holder of Imris with 26.7%, while total insider ownership accounts for 35%. The management team is comprised of very technically astute individuals who have a reputation among clients for their knowledge and professionalism.
From a financial prospective, Imris estimates that the number of hospitals with expertise in neurosurgery is (the market for IMRISneuro) is 990 versus their current install base of 34. Wedbush estimates that there are 781 stroke centers in the US (IMRISnv) and 669 heart centers (IMRIScardio) that have high patient volumes and are experienced in handling complex cases. The total global market for each of their current three products, according to their research, could be nearly 5,200 centers. Compare this to the 41 systems they have sold since 2005. Regardless of what the total number of customers is, Imris is nowhere near reaching the limit. Sales of new units could easily double or triple, while they will also get recurring service and maintenance revenue from a widening install base. Sales backlog has grown 44% YoY to $120mm, of which at least 80% will be realized in the next 12 months.
The company may be trading at 2.3x 2011 EV/sales, but this is not Coke or Proctor and Gamble. Imris has a good shot at doubling their sales in the next 3 or 4 years. They have a strong management team with a big ownership of the business. There is no competitive threat as Imris has copyrights on their mobile technology until 2015. The downside risk is that Siemens supplies critical components in the Imris system, and are also a competitor. Sales are also choppy as single wins or losses greatly affect quarterly results when the company is small. Hospitals on mass could also cut budgets (unlikely as sales grew throughout 2008 and 2009) or regulatory approval for new products could be slower than usual. You risk selling down to a multiple of book (at which someone scoops the patents) or 1x sales, since thats how tech people like to look at it, say $3 on a complete fire sale. I view this as highly unlikely. You could lose 50% to make 2 or 3 times your money within 3 to 4 years. I view the bullish argument as a much higher probability given the competitive advantages and growth potential I mentioned above.
Monday, January 3, 2011
Mega Brands 10% coupon first lien bonds (105.25 last ~8.5% YTM)
Mega Brands is a Montreal based company engaged in designing, manufacturing and marketing of two product lines: toys and stationary products. Between 2006 to 2009 the company had a slew of lawsuits and product recalls that left it teetering on the brink of bankruptcy, but after a recapitalization and the signing of new brand licenses Mega Brands is poised to be a prime turnaround candidate. While the stock should also do well, a large outstanding issue of in the money warrants will dilute the company's upside. The bonds on the other hand are reflecting a much higher risk profile than is warranted.
Before the company's troubles began, Mega Brands built itself from its humble beginnings as a toy distribution business run by the Bertrand family into a design and marketing entity with $550mm in sales in 2006. Part of this growth was through its 2005 acquisition of Rose Art, which is primarily responsible for its woes from then on. Rose Art's Magnetix line, representing 40% of the new acquisitions sales, was responsible for the death of a toddler from magnet ingestion. What ensued was mass product recalls, abandonment of the product line, and charge-offs totalling $123mm. In addition, the company engaged in costly litigation ($55mm set aside as loss provision) with the former owners of Rose Art regarding earn-outs on the acquisition. The resulting public relations nightmare caused sales to fall from $550mm in 2006 to $338mm in 2009, while at the same time the company was saddled with over $400mm in debt from the Rose Art purchase. It also did not help that these events coincided with the worst recessions in a generation.
In 2009 the company's independent directors met several times to discuss the possibility of recapitalization or the sale of some or all of the company's operations. They settled upon a complete recapitalization, in early 2010 cancelling existing debt with the issuance of $229mm of new equity, warrants, senior 10% coupon bonds, plus the establishment of a $50mm asset based credit facility (senior to the bonds) for working capital requirements. Existing holders Fairfax Financial, AIM Trimark and the Bertrand family all bought the issuance, which reduced total debt by $300mm and reduced interest expense by $30mm/year. Pro forma numbers suggest interest coverage (adjusted EBITDA to interest expense) increased to 1.3x from -4x for 2009 and 2.8x from -11.7x for 2008 post recapitalization. Not stunning numbers, but manageable even during years that were complete disasters.
A string of positive developments makes the recapitalization look like it will have a more positive effect than the pro forma historical numbers suggest. In September the company's legal battle with LEGO ended in Europe, freeing up Europe as a growth market for its traditional Mega Blok product. Mega Brand toys are now regaining shelf space at key retailers such as Wal-Mart, Toy's R Us, Target, etc... The company has seen strong sales of its proprietary Dragon's brand, as well as in its Thomas and Friends (named on the hot 20 toys of 2010 list), Iron Man II , and Halo licenses. In early December Mega Brands inked a new licensing agreement with Electronic Arts for Need For Speed. Q3 2010 toy sales were 18% higher YoY and the company is back in the black, earning $16mm on sales of $128mm.
What I am betting on is that Mega Brands can return to its previous profitability before the Rose Art fiasco. The company successfully built relationships with licensors and distributors, and was able to run a very profitable business of proprietary and licensed toys. The bad PR and litigation has battered the company, though if it can regain its past operating performance the recapitalized entity will vastly increase its interest coverage ratio and the now in-the money warrants will be exercised to repay the principal on the bonds. Management thinks that if they implement this turnaround they can reach $500mm in sales in 5 years with EBITDA margins in the mid teens in 3-5 years. The actions management have shown since recapitalization point to them being vigilant and hungry to return to what made them successful pre Rose Art. Even if they stumble, a base case scenario is a return to 2009 sales levels where pro forma numbers show that they will still be able to cover interest payments. I view that scenario as less likely given how quickly the chains have restocked Mega Brand products and the pipeline of upcoming products, plus management's undivided attention to the core business and not litigation or financial difficulties.
I am avoiding the common stock because of the dilution of warrant exercise. The warrant exercise is why the bonds look good, because the stock will be worth more than the $0.50 strike should the company prosper and the cash injection pays back the principal, regardless of whether the company is able to refinance the debt. Its not that I think the stock is a bad investment, I just like that the bonds are marginable and benefit indirectly if the stock does well. The street however is bullish on the stock, with 4 analysts with buys on the stock and a target price of 0.89 vs. 0.65 currently.
Before the company's troubles began, Mega Brands built itself from its humble beginnings as a toy distribution business run by the Bertrand family into a design and marketing entity with $550mm in sales in 2006. Part of this growth was through its 2005 acquisition of Rose Art, which is primarily responsible for its woes from then on. Rose Art's Magnetix line, representing 40% of the new acquisitions sales, was responsible for the death of a toddler from magnet ingestion. What ensued was mass product recalls, abandonment of the product line, and charge-offs totalling $123mm. In addition, the company engaged in costly litigation ($55mm set aside as loss provision) with the former owners of Rose Art regarding earn-outs on the acquisition. The resulting public relations nightmare caused sales to fall from $550mm in 2006 to $338mm in 2009, while at the same time the company was saddled with over $400mm in debt from the Rose Art purchase. It also did not help that these events coincided with the worst recessions in a generation.
In 2009 the company's independent directors met several times to discuss the possibility of recapitalization or the sale of some or all of the company's operations. They settled upon a complete recapitalization, in early 2010 cancelling existing debt with the issuance of $229mm of new equity, warrants, senior 10% coupon bonds, plus the establishment of a $50mm asset based credit facility (senior to the bonds) for working capital requirements. Existing holders Fairfax Financial, AIM Trimark and the Bertrand family all bought the issuance, which reduced total debt by $300mm and reduced interest expense by $30mm/year. Pro forma numbers suggest interest coverage (adjusted EBITDA to interest expense) increased to 1.3x from -4x for 2009 and 2.8x from -11.7x for 2008 post recapitalization. Not stunning numbers, but manageable even during years that were complete disasters.
A string of positive developments makes the recapitalization look like it will have a more positive effect than the pro forma historical numbers suggest. In September the company's legal battle with LEGO ended in Europe, freeing up Europe as a growth market for its traditional Mega Blok product. Mega Brand toys are now regaining shelf space at key retailers such as Wal-Mart, Toy's R Us, Target, etc... The company has seen strong sales of its proprietary Dragon's brand, as well as in its Thomas and Friends (named on the hot 20 toys of 2010 list), Iron Man II , and Halo licenses. In early December Mega Brands inked a new licensing agreement with Electronic Arts for Need For Speed. Q3 2010 toy sales were 18% higher YoY and the company is back in the black, earning $16mm on sales of $128mm.
What I am betting on is that Mega Brands can return to its previous profitability before the Rose Art fiasco. The company successfully built relationships with licensors and distributors, and was able to run a very profitable business of proprietary and licensed toys. The bad PR and litigation has battered the company, though if it can regain its past operating performance the recapitalized entity will vastly increase its interest coverage ratio and the now in-the money warrants will be exercised to repay the principal on the bonds. Management thinks that if they implement this turnaround they can reach $500mm in sales in 5 years with EBITDA margins in the mid teens in 3-5 years. The actions management have shown since recapitalization point to them being vigilant and hungry to return to what made them successful pre Rose Art. Even if they stumble, a base case scenario is a return to 2009 sales levels where pro forma numbers show that they will still be able to cover interest payments. I view that scenario as less likely given how quickly the chains have restocked Mega Brand products and the pipeline of upcoming products, plus management's undivided attention to the core business and not litigation or financial difficulties.
I am avoiding the common stock because of the dilution of warrant exercise. The warrant exercise is why the bonds look good, because the stock will be worth more than the $0.50 strike should the company prosper and the cash injection pays back the principal, regardless of whether the company is able to refinance the debt. Its not that I think the stock is a bad investment, I just like that the bonds are marginable and benefit indirectly if the stock does well. The street however is bullish on the stock, with 4 analysts with buys on the stock and a target price of 0.89 vs. 0.65 currently.
Tuesday, November 2, 2010
Westaim ($0.495 last)
After completing the acquisition of JEVCO, Westaim is a leading Canadian provider of P&C insurance products, specializing in non-standard auto and motorcycle, recreational vehicles, commercial auto, as well as property and liability. Historically Westaim was a holding company of a slew of unprofitable businesses, including Nucryst Pharmaceuticals and iFire Technologies. Needless to say neither of these businesses made any money. In 2009 alternative asset manager Goodwood Inc. acquired 20% of Westaim with the intention of using it as a shell company by disposing of the two unprofitable holdings, leaving effectively a small sum of cash and tax loss carryforwards.
JEVCO was locked within insurance holding company Kingsway Financial. Kingsway's Canadian CEO Serge Lavoie removed JEVCO from unprofitable lines of business like cross border trucking and focused on efficiency gains in its core non-standard auto business, for instance by introducing a web based portal from brokers. In early 2010 Westaim, JEVCO, and Kingsway hammered out a deal whereby Westaim would buy JEVCO for $261mm, or 95% of book value. The deal was financed by Alberta Investment management Corp ($148mm), insiders of Jevco and Westaim ($17.5mm), and a brokered placement for the balance. The deal worked out to $0.50 per share.
What I like about the story, as in any asset conversion story, is that management becomes directly responsible for the firm's results. This gives them autonomy over their roles and provides justification for higher compensation down the road. It is also a vote of confidence that management bought the deal and now have skin in the game.
Financials for JEVCO are broken out in some company filings, but these only offer a glimpse of what the consolidated Westaim results can look like. JEVCO was under the influence of Kingsway (hence engaged in less profitable or riskier underwriting). Now that the company is leaner and can use its dominant market position to improve its combined ratio. The company also just pushed through a 10% rate hike and is benefiting from Ontario's new claims rules that limit the damages a customer can claim in the event of an accident.
WED's valuation is compelling. At 0.495/share, the market cap is $328mm. Book value is $353mm which consists of $1B in investment grade corporate and government securities earning 3% or so. Historically JEVCO has been very conservative with their loss reserves and have adjusted them higher, so realized claims may well be lower. So basically you are buying a levered investment grade bond fund at a discount to NAV. Their tax loss carry forwards give them a near zero tax rate over the next year and a half, so $1b yielding 3% is $30mm per year. Historically they have operated at a combined ratio in the 95% range, but even if underwriting breaks even over a prolonged period you are getting a 9% cash flow yield on high quality debt instruments.
The fact that management bought a big slug of stock makes me think prolonged periods of operating loss are not too likely. WED could also get more aggressive and throw equity into its $1B portfolio to increase yield.
JEVCO was locked within insurance holding company Kingsway Financial. Kingsway's Canadian CEO Serge Lavoie removed JEVCO from unprofitable lines of business like cross border trucking and focused on efficiency gains in its core non-standard auto business, for instance by introducing a web based portal from brokers. In early 2010 Westaim, JEVCO, and Kingsway hammered out a deal whereby Westaim would buy JEVCO for $261mm, or 95% of book value. The deal was financed by Alberta Investment management Corp ($148mm), insiders of Jevco and Westaim ($17.5mm), and a brokered placement for the balance. The deal worked out to $0.50 per share.
What I like about the story, as in any asset conversion story, is that management becomes directly responsible for the firm's results. This gives them autonomy over their roles and provides justification for higher compensation down the road. It is also a vote of confidence that management bought the deal and now have skin in the game.
Financials for JEVCO are broken out in some company filings, but these only offer a glimpse of what the consolidated Westaim results can look like. JEVCO was under the influence of Kingsway (hence engaged in less profitable or riskier underwriting). Now that the company is leaner and can use its dominant market position to improve its combined ratio. The company also just pushed through a 10% rate hike and is benefiting from Ontario's new claims rules that limit the damages a customer can claim in the event of an accident.
WED's valuation is compelling. At 0.495/share, the market cap is $328mm. Book value is $353mm which consists of $1B in investment grade corporate and government securities earning 3% or so. Historically JEVCO has been very conservative with their loss reserves and have adjusted them higher, so realized claims may well be lower. So basically you are buying a levered investment grade bond fund at a discount to NAV. Their tax loss carry forwards give them a near zero tax rate over the next year and a half, so $1b yielding 3% is $30mm per year. Historically they have operated at a combined ratio in the 95% range, but even if underwriting breaks even over a prolonged period you are getting a 9% cash flow yield on high quality debt instruments.
The fact that management bought a big slug of stock makes me think prolonged periods of operating loss are not too likely. WED could also get more aggressive and throw equity into its $1B portfolio to increase yield.
Monday, July 12, 2010
Sun Gro Horticulture ($4.35 last)
Sun Gro Horticulture is a vertically integrated producer, processor and distributor of peat moss and bark based growing media to the professional growing market. The investment thesis in Sun Gro is compelling due to its low valuation on a price to book, price to earnings, and DCF basis, combined with its dominant "price setter" market position as well as shareholder base with a history of takeovers.
Sun Gro leases peat bogs from provincial governments in Canada and mines peat moss. The raw peat moss is shipped to its wholly owned network of processing facilities that creates custom mixes that tailor to a professional growers market, namely nurseries and greenhouses. While Sun Gro is the largest company of its kind in North America, there are two main competitors to Sun Gro: Premier Tech and Conrad Fafard. Premier Tech is an industrial, agricultural and environmental company that has amassed a 24% equity position in Sun Gro and continues to actively buy stock on the open market. Also, in 2007 Premier Tech itself was the target of a hostile takeover by Oakwest Capital before inevitably going private through a management led buyout. Oakwest now owns 7.8% of Sun Gro. Conrad Fafard was bought by European agricultural powerhouse Syngenta in 2006. Worth noting is that Sun Gro's management has also recently been purchasing stock in the open market.
Sun Gro hit a number of stumbling blocks over the past few years. Management used debt to consolidate the professional growers distribution chain through a slew of acquisitions instead of using its internal free cash flow. Instead, due to its income trust structure it passed the majority of its cash flows to shareholders. During late 2008 the company announced the permanent suspension of this distribution and intended conversion to a corporation. Also at this time the company realized a 10%-15% decline in organic sale volumes (overall volume and revenue stayed roughly flat due to higher ASPs and acquisitions) and a large increase in the US dollar. As a Canadian firm selling into the US (85%+ of sales) a strong USD is normally good, but it had a large currency hedge in place that resulted in a $25mm marked to market loss. At the present time the firm has a $75mm short USDCAD hedge in place at 1.12, evenly spit over 2010 and 2011.
In 2009 the company put these missteps behind them, earning $19mm and generating $17mm in FCF. Management used this cash flow to pay down debt and is committed to delevering the balance sheet. On a trailing basis, including Q1/10 where volumes grew 9% YoY, Sun Gro is trading at a PE of 4.5x, 0.8x book value (1.3x tangible book), and has a 20% free cash flow yield. Going forward, assuming a very conservative flat volume and ASP profile plus a higher corporate tax rate, the company can generate $15mm in FCF. Investment broker dealer Cormark has FY2011 EBITDA of $28.5mm and notes that Premier Tech went private at 7x trailing EBITDA and Conrad Fafard was bought by Syngenta AG at nearly 12x trailing EBITDA. Sun Gro currently trades at 3.4x FY2011 EBITDA, and should have a greatly reduced debt load by that point. Cormark also notes that much of Sun Gro's idle off season capacity could be utilized by retail, private label brands to add upwards of $100mm in additional sales with limited CapEx. To be conservative of course I have left this out.
What I like about Sun Gro is that it is a relatively straightforward story to understand. They are already generating loads of cash and have an irreplaceable asset base with high barriers to entry and limited competition. Management are great at disclosure, are develering the balance sheet, and have bought stock in the open market recently. The company has a shareholder base with a history of unlocking value through takeovers. In absolute value terms, the company is trading at a discount to book value of $5.09/share, and if you value the business as an annuity with a very conservative $15mm in FCF @ 10% it is worth well over $6/share. On a risk reward basis, Premier Tech buys stock between $4 and $4.10, so the current $4.35gives you a $0.35 downside to a $0.65 to $1.65 upside.
Sun Gro leases peat bogs from provincial governments in Canada and mines peat moss. The raw peat moss is shipped to its wholly owned network of processing facilities that creates custom mixes that tailor to a professional growers market, namely nurseries and greenhouses. While Sun Gro is the largest company of its kind in North America, there are two main competitors to Sun Gro: Premier Tech and Conrad Fafard. Premier Tech is an industrial, agricultural and environmental company that has amassed a 24% equity position in Sun Gro and continues to actively buy stock on the open market. Also, in 2007 Premier Tech itself was the target of a hostile takeover by Oakwest Capital before inevitably going private through a management led buyout. Oakwest now owns 7.8% of Sun Gro. Conrad Fafard was bought by European agricultural powerhouse Syngenta in 2006. Worth noting is that Sun Gro's management has also recently been purchasing stock in the open market.
Sun Gro hit a number of stumbling blocks over the past few years. Management used debt to consolidate the professional growers distribution chain through a slew of acquisitions instead of using its internal free cash flow. Instead, due to its income trust structure it passed the majority of its cash flows to shareholders. During late 2008 the company announced the permanent suspension of this distribution and intended conversion to a corporation. Also at this time the company realized a 10%-15% decline in organic sale volumes (overall volume and revenue stayed roughly flat due to higher ASPs and acquisitions) and a large increase in the US dollar. As a Canadian firm selling into the US (85%+ of sales) a strong USD is normally good, but it had a large currency hedge in place that resulted in a $25mm marked to market loss. At the present time the firm has a $75mm short USDCAD hedge in place at 1.12, evenly spit over 2010 and 2011.
In 2009 the company put these missteps behind them, earning $19mm and generating $17mm in FCF. Management used this cash flow to pay down debt and is committed to delevering the balance sheet. On a trailing basis, including Q1/10 where volumes grew 9% YoY, Sun Gro is trading at a PE of 4.5x, 0.8x book value (1.3x tangible book), and has a 20% free cash flow yield. Going forward, assuming a very conservative flat volume and ASP profile plus a higher corporate tax rate, the company can generate $15mm in FCF. Investment broker dealer Cormark has FY2011 EBITDA of $28.5mm and notes that Premier Tech went private at 7x trailing EBITDA and Conrad Fafard was bought by Syngenta AG at nearly 12x trailing EBITDA. Sun Gro currently trades at 3.4x FY2011 EBITDA, and should have a greatly reduced debt load by that point. Cormark also notes that much of Sun Gro's idle off season capacity could be utilized by retail, private label brands to add upwards of $100mm in additional sales with limited CapEx. To be conservative of course I have left this out.
What I like about Sun Gro is that it is a relatively straightforward story to understand. They are already generating loads of cash and have an irreplaceable asset base with high barriers to entry and limited competition. Management are great at disclosure, are develering the balance sheet, and have bought stock in the open market recently. The company has a shareholder base with a history of unlocking value through takeovers. In absolute value terms, the company is trading at a discount to book value of $5.09/share, and if you value the business as an annuity with a very conservative $15mm in FCF @ 10% it is worth well over $6/share. On a risk reward basis, Premier Tech buys stock between $4 and $4.10, so the current $4.35gives you a $0.35 downside to a $0.65 to $1.65 upside.
Sunday, June 20, 2010
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