Monday, 21 April 2014

Sifting Through Thrifts - An Introduction to Thrift Conversions

Popularized by Seth Klarman’s book, ‘Margin of Safety’, thrift conversions provide an interesting opportunity set for investors willing and able to fish in smaller ponds.

Aside from the fact that the idea is advised by Seth Klarman, ‘the master of risk-averse value investing’, and backed David Chilton[1], ‘the wealthy barber’, thrift conversions have also produced abnormal returns for decades.
Several studies have shown impressive one-day returns following thrift IPOs - a couple of them are listed in the references section. Perhaps more interesting than single day returns is the long-term performance of thrift conversions. Barron’s article, ‘Like Money in the Bank’, published Dec-2010, reported that the SNL Thrift MHC Index, which invests in partially converted thrifts (explained later), returned 188% over the previous decade, outperforming the Russell 2000 by a factor of 3. The performance is even more impressive considering the period encompasses one of the worst financial crises in history, brought by a nationwide housing crash.
More recently, a section in the Oct-2010 issue of Manual of Ideas[2] - ‘Thrift Conversions: Is Anyone Paying Attention?’ published a list of 34 partially converted thrifts. The average return for these boring, overcapitalized, regional banks has been 69%, managing to outpace the S&P 500 Index (58%, both returns exclude dividends) even during a fast rising market. Looking at the five cheapest securities as measured by market value to tangible assets, the average return has been 96%.

‘The term “thrifts” includes a variety of institutions and charter names including savings banks, savings and loan associations, and cooperative banks. Thrifts may be either mutually- or stock-owned, are not exempt from corporate income taxes, are not bound by fields of membership or (under the federal charter) by branching restrictions, and typically face fewer restrictions on their investment and lending powers than credit unions.’[3]

Thrift conversion refers to the process of converting a mutually-owned thrift to a publicly traded company, also known as a stock-thrift. There are several tics and kinks in the two common conversion methods that make it such a fertile fishing pond:
1)      The Standard Conversion:
In a standard mutual-to-stock thrift conversion, the existing member’s claim on retained earnings is not exchanged for shares of stock or cash in proportion to their deposits. Instead, the retained earnings are exchanged for rights to purchase stock. Therefore, a hypothetical pre- and post-conversion balance sheet for a thrift would look something like this:
Conversion leads to two immediate benefits:                      i) investors participating in the IPO immediately receive a net worth per share greater than their own contribution (i.e. through the retained earnings of joint members); and ii) the additional equity raised through IPO generally leads to healthy capitalization ratios even for previously undercapitalized thrifts.
While standard conversions provide great opportunities to safely deploy capital, the number of conversions is normally limited to a handful per year.
2)      The Mutual Holding Company Conversion:
Another method of conversion is known as the mutual holding company (MHC) method. In the process, 100 percent of the mutually-owned thrift shares are first transferred to the MHC. The MHC then sells up to 49 percent of the shares of its wholly-owned thrift subsidiary in a first-step conversion, retaining control. Upon completion of the first-step, these thrifts are referred to as partially converted thrifts or MHC owned thrifts. The impact on the balance sheet is identical to the standard conversion method, with the exception that not all shares have been sold.
Partially converted thrifts present another larger opportunity set with normally 20 to 50 companies falling in this category at any given time. The quoted capitalization of these securities is overstated, and can easily be overlooked. For example, suppose a partially converted thrift is trading at $10 per share, with 1 mln shares outstanding, of which 60% are held by a MHC. While the market capitalization of this company would be $1,000,000, the true market value of the company is $400,000. The MHC held shares are equivalent to treasury shares that may or may not be sold to investors in the future.
Subject to OCC approval and 50 percent of eligible votes, MHCs may engage in second-step conversion, whereby the remaining shares are sold for the appraised value and the MHC is dissolved.

This is intended to be a very brief introduction to thrift conversions and MHCs. I encourage those interested in learning more to read through the material in the references section – the gathered papers and articles do a much better job of explaining thrifts, conversions, and everything in between.
Further, there are several factors that one should consider before investing in any lending institution including: the quality of loan portfolio, capitalization ratios, loan loss reserves, and management incentives.

I can't seem to find a way to put the entire table of partially converted thrifts, please refer to pdf.

Four of the first five securities listed in the opportunity set lost money in the previous year of operations, which begs the question - are these stocks justly cheap?
While it is clear there are some lowly banks on the list, there is still value in their assets. Banks operate a commoditized business – they provide loans at a rate that is able to cover the cost of capital and operating expenses. Economies of scale can be tremendous for smaller banks, making them ideal candidates for consolidation. The following help support this point:
1)      Economies of scale:
Efficiency ratios (a measure of a bank’s non-interest expense to revenues, higher ratios indicate less efficient bank) for small banks tend to be much higher than for large banks. As banks expand geographically, they are able to grow assets while lowering per unit cost of additional assets such as employee, advertising, and overhead expenses. The chart below, from a FDIC study shows efficiency ratios for community banks and larger non-community banks – average efficiency ratio for community banks lies around 72% versus 65% for non-community banks[4]. Another measure for economies of scale is the assets per employee ratio – which for community banks stands at $4 mln per employee versus $5.3 mln for non-community banks4.

2)      Trend of consolidation:
The industry agrees with the economies of scale argument. Total number of U.S. commercial banks has decreased from 14,495 in 1984 to 6,532 by the end of 2010. The rate of consolidation in smaller banks has been even greater – the number of savings institutions has fallen from 3,566 to 1,128 over the same period[5]. Industry consolidation has coincided with increased profitability as measured by return on equity or assets – the chart below shows return on assets for all commercial banks from 1934 to 2003, with an upward trending slope. Generally speaking, consolidation and higher profitability have coincided for banks – hopefully creating better businesses and shareholder value along the way.

The short answer to whether unprofitable banks are worth a look is yes – even unprofitable banks can be good investments at the right valuation since their assets can be much more accretive to larger banks. The key concerns however are the quality of loan portfolio, capitalization ratios, and loan loss reserves.


1)      SFSB, Inc. (OTC:SFBI):
Founded in 1900, the Baltimore based Slavie Federal Savings Bank is by far the cheapest on the list, trading at a MV/TA ratio of 0.2%, and P/TBV ratio of 0.06x. There are reasons for this valuation – the bank’s efficiency ratio was 119% in 2013 (meaning for every $1 of interest income earned, it spent $1.19 on operating expenses, excluding cost of capital), and more importantly it has significant nonperforming loans[6]. Loan loss reserves were 4.2% at the end of 2013, and the percentage of nonperforming loans was at 11.3% at the end of 2012 (2013 numbers will be released with annual report in May). Despite the troubles, the asset backed loans and residential focus could make for a fitting candidate in a larger portfolio of loans, especially at current prices.

2)      Mid-Southern Savings Bank, FSB (OTC:MSVB):
Operated out of Salem, Indiana, MSVB is a deep-value situation, currently priced for a MV/TA ratio of 2.0%, and P/TBV of 0.2x. During four of the last five years, the bank has grown its assets, generated a profit, and earned a return on equity greater than 3% (4% average). The bank maintains a healthy 10% equity to asset ratio with an efficiency ratio ranging from 45% to 65%. Loan loss reserves stood at 2.39% at the end of 2013, while nonperforming loans were 5.52% of total loan portfolio. The increase in nonperforming loans in 2013 is concerning, however given the bank’s valuation, operating efficiency, and healthy loan loss reserves, it is definitely worth a look – based on its trailing 5-year average, MSVB is trading at 5.9x earnings.

3)      Ben Franklin Financial Inc. (OTC:BFFI):
Founded in 1893, Ben Franklin Financial is headquartered in Arlington Heights, Illinois. Current MV/TA ratio stands at 2.0%, with a P/TBV of 0.2x. BFFI is a classic example of a small unprofitable bank that could be much more successful in a larger portfolio. With $98 mln in assets, the bank’s efficiency ratio tends to hover around 100% with a slowly declining asset base. The good news is that nonperforming loans as a percentage of total loans of 2.8% are fully covered by the loan loss reserves, making it an apt candidate for consolidators.

4)      Pathfinder Bancorp, Inc. (NASDAQ:PBHC):
Pathfinder Bancorp, Inc. was founded in 1859, in Oswego County, New York. Despite posting consistent operating results with asset growth, PBHC trades at a MV/TA ratio of 3.1%, P/TBV of 0.6x, and 6.2x earnings. From 2009 to 2013, the bank has grown its assets by 35%, deposits by 38%, and tangible book value per share by 31%. PBHC operates at a 70% to 80% efficiency ratio, which while high, allows it to earn a respectable 6% to 8% return on equity. Nonperforming loans as a percentage of total loans were 1.57% at the end of 2013, well matched by its 1.48% loan loss reserves (suggesting cash earnings could be higher than reported numbers). Pathfinder Bancorp provides an opportunity to buy a well-managed, quality business, at a fair price.

5)      Greene County Bancorp, Inc. (NASDAQ:GCBC):
With its annual report titled, “Uncovering hidden opportunities”, The Bank of Greene County is a natural fit for this report. The bank was formed as a savings and loan institution in 1889, in Catskill, New York. Currently priced at 7.5% of asset value and 0.8x TBV, GCBC doesn’t appear to be a bargain on first sight. The bank is however incredibly efficient at employing its $650 mln book, consistently generating >1% ROA and >10% ROE, backed by an efficiency ratio of under 60%. Nonperforming loans were 1.92% of the portfolio, fully covered by its 1.92% loan loss reserves (again suggesting that cash earnings could be much higher than reported numbers). The company’s 7.6x earnings valuation moves from cheap to bargain territory once we consider its growth rate – over the last five years, GCBC has grown its assets by 38%, deposits by 40%, book value by 39%, and earnings by 56% - operating like a well-oiled machine.

6.       Oconee Federal Financial Corp. (NASDAQ:OFED):
Established in 1924, Oconee Federal serves Oconee County in South Carolina. The company trades at 8.1% of its asset value, 0.4x TBV, and 7.8x earnings. Another well-run institution, Oconee generates >1% ROA and >5% ROE, with an extremely conservative 20% equity to asset ratio. Over the last four years the company has maintained an efficiency ratio of under 50%. The company does have slim loan loss reserves of 0.35%, versus nonperforming loans of 1.44%. While the bank is not growing its assets, it is effectively growing assets per share by repurchasing 27% of shares issued in its first-step conversion completed in 2011 (repurchase program was started in 2012). Oconee offers a well-run, undercapitalized bank (could effectively double its earnings by increasing its leverage to 10% equity/assets), that is actively repurchasing its shares at a very attractive valuation.

Monday, 31 March 2014

Mawson West (TSX:MWE) - Cheap but not 'Stupid Cheap'

While some companies don't screen well (hidden assets, unprofitable divisions, bloated pension liab.), others with limited-life assets (miners, O&G, airlines, equipment rental, shipping) can often screen far too well relative to their intrinsic value. Mawson West ("Mawson") unfortunately falls into the latter category. 

I first came across Mawson after it popped up on a few 'stupidly cheap' screens and from reading a couple of writeups on the name. Based on trailing numbers, Mawson trades at 0.5x EV/EBITDA and 1.0x P/CF, while having half of its C$93 mln market cap sitting in cash. That looks stupid cheap. And there are a number of possible reasons for this valuation: i) small-cap < $100 mln market cap company; ii) mining stock (I know, why even bother); iii) operations in Africa, Democratic Republic of Congo to be more precise; iv) and no dividend or buyback (quite the shocker for a mining company). Now while the Congo risk is difficult to discount due to political instability, possibility of nationalization, and ongoing tax and royalty hike discussions, Mawson appears cheap enough to warrant a further look. 

The bad
Low hanging fruit has been picked - Mawson currently has one operating asset, the open-pit Dikulushi mine. The company acquired the mine from Anvil and had been processing low-grade stockpilled material on site, as well as deepening the pit to extract high-grade material at the bottom - both of which are now depleted. This has been a great asset operating at $1.35/lb cash costs ($0.80/lb Cu incld. silver credits) with simple open-pit operations, and a well functioning processing plant. It has also been a great investment as the 83 mln shares issued (now worth ~C$46 mln) have generated C$108 mln in EBITDA and C$95 mln in CFO over the last twelve months. With the open-pit depleted, the main ball has come to an end, but investors do have a free ticket to the after-party (...continued later, in the good part). 
Congo risk should not be overlooked - the Congolese government continues to have on and off discussions regarding imposing a royalty, hiking mining taxes, or banning concentrate exports (forcing miners to build processing facilities). Something will likely be done, as aside from the threat of terrorism/nationalism, Congo is probably one of the best places to start a mine in the world. There is no royalty, mines are exempt from taxes for the first five years of operations, and taxed at a very reasonable 16% thereafter (eventually rising to 40% after 15 years). 
Valuation not quite 'Stupid Cheap' - here's a summary of Mawson's assets:
Dikulushi underground - following depletion of the open-pit reserve, Mawson will continue mining the high-grade  deposit via underground operations. The rate of production will slow to half of the prior 21,000 ton per year pace, at $2.10/lb cash costs ($1.50/lb Cu with silver credits). The current resource only supports 9 months of operations, and management wants to extend the mine-life to 5-years. At the current 9 month life, the project is worth C$9 mln ($0.05/sh).
Kapulo open-pit - Mawson's core asset has always been the Kapulo mine located roughly 150km NE from Dikulushi. The open-pit project is set to start operations in the second half of the year with the plant ~70% complete. The remaining ~US$60mln of development costs will be funded through cash on hand (US$48mln), continuing cashflow from Dikulushi, and a refinanced debt facility. Kapulo hosts a large >7MT reserve at 3.2% copper that can support a 10-year mine life, producing ~16kT/year at $1.90/lb Cu cash costs. At $3/lb Cu and a 10% discount rate, the project is worth C$116 mln or $0.67/sh.
Sum of Parts - corporate adjustments: +$0.33/sh in cash and options, -$0.31/sh for debt and SG&A. Adding these to the mines, Mawson is worth around $0.74/sh for +34% upside. Which is not bad considering the valuation is at the spot Copper price, company is fully funded, and a large chunk of the value is in the simple open-pit project.

The Good
Grade and Longevity - From working in the mining industry, if I learned anything, it would have to be: i) grade is king - be as close to the toe of the boot as possible in terms of operating costs; and ii) invest in long-life reserves to provide upside during periods of commodity price volatility. The high grade is observable with world class cash costs at Dikulushi, even after the deposit shifts to underground mining. While Kapulo offers great longevity with a 10-year mine life based on current reserves, with competitive cash costs. 
Free Options after initially valuing the mines, I was pretty disappointed. Here's a company trading at 1x CF, with half its market cap in cash, yet only worth a measly 34% premium based on intrinsic value. But there's still something here. The biggest upside for Mawson is through adding reserves. Now before I indulge in this discussion, I'm not a geologist and possess virtually no knowledge of the Congo Copper belt, and yes, I do understand that every resource company is always promising additional resources. But even a layman like myself can build some educated scenarios. With Mawsons' infrastructure already in place, the threshold for additional resources to be accretive is very low. I have built three simple scenarios for potential upside:
i) Dikulushi Underground extended - if Mawson is able to extend the underground resource life by an additional 2 years (management feels they can get 5 years total out of the deposit), additional value to shareholders would be ~C$52 mln or +$0.30/sh - total NAV $
ii) Dikulushi Satellite deposit - if Mawson is able to build a reserve 1/5th the size of 3.6MT mined ore at Dikulushi from nearby deposits, additional value to shareholders would be ~C$54 mln or $0.31/sh - total NAV $1.30/sh. Two nearby deposits will be reporting initial reserves in the coming months. The resource size, grade, and further prosperity of these deposits can yield significant value.
iii) A rise in copper prices - combining the above two scenarios with $3.50/lb Cu prices into the future would add another $0.70/sh, bringing our NAV to $2.03.

I'm not a fan of 'leap-of-faith investing' (prophesying expansion and margin improvements out of thin air). And though the three scenarios above have yet to materialize, the likelihood of one or more of these options ending in-the-money is high. When valuing upside options, like anything else in investing, price is the key determinant of your risk and reward, and the price to be paid for Mawson's options is currently zero.

Thursday, 20 February 2014

Maxim Power Corp - Attractively Priced, but Regulatory Risk Remains

Description. MAXIM Power Group (“Maxim”) is an Independent Power Producer (“IPP”) engaged in the acquisition, development, and operations of power generation facilities. The company operates 804 megawatts (“MW”) of electric power in Canada, U.S., and France and 118 MW of thermal power solely in France. The forty-one electric facilities are split between thirty-seven gas fired plants (638 MW), three are LFG and waste heat recovery plants (16 MW), and one coal plant in Alberta (150 MW). The company also has three attractive development projects in its pipelines – a fully-permitted 18.9 MT met coal reserve, a 190 MW fully permitted nat-gas power project, and a proposed 520 MW nat-gas expansion to its existing coal plant.

History. Maxim checks off several boxes for a stock that could contain hidden value: i) small cap security with ~C$150 mln market cap; ii) illiquid stock – average volume traded is 70,000 shares, or C$200k daily; iii) major shareholders are looking for ways to maximize the company’s value and/or their return capital; and iv) a recent sales agreement that was terminated due to a FERC inquiry sent stock tumbling 25%, and currently trade at 0.6x book value.

The company is no stranger to idea-generation sites with multiple submissions on VIC and SumZero, however every time investors feel the company has found a way to unlock its value, something goes awry – in 2012 Alberta’s power prices fell despite steady economic activity and a new carbon emission legislation shortened the economic life of its coal plant; in 2013 a definitive sales agreement was terminated, while another expected agreement failed to materialize. Despite all the blunders, Maxim’s assets are performing better than ever, the balance sheet is as robust as ever, the company has a clear divestment strategy, and yet trades near all-time lows based on enterprise value.

Operations. In the past, the company’s split-persona between an operator and a developer caused the market to discount its operating assets (can’t distribute income to shareholders), and not give any value for its development projects (too small to develop its projects alone). Rightly so, in late-2012 major shareholders who have seen the value of their shares go nowhere over the last decade shifted the company’s focus to developing the Alberta plants while divesting the well-performing operating portfolio and coal reserve. The company has stated it will not develop the two nat-gas projects solo due to the binary nature of single project development, and will seek an off-take or JV.

Maxim’s poor share price performance is explained by its deteriorating return on capital (exhibit 1) – a function of peak market acquisitions and inconsistent performance from its assets. After five years of muddling through, Maxim is firing on all cylinders again with power prices in its key markets reaching 2007-2008 levels, boosting return on capital employed back into double digit territory. On a TTM basis Maxim has generated $53 mln in EBITDA.

Valuation. For simplicity sakes I’ve valued Maxim on a multiples basis, using 8x pre-tax CF (5x for Milner) while adjusting for cyclicality, debt and closure costs, and Summit’s NPV (exhibit 2). I’ve tried to be conservative in my valuation leaving room for upside – the multiples used maybe conservative for a predictable business; if the Alberta power market remains tight, Milner could add an additional $0.20/sh per year; and I’m only adding half of Summit’s NPV, which could provide another $0.78/sh. Whole, Maxim’s portfolio should be worth at least $4/sh for 40% upside.

Conclusion. While I would love to tell you that Maxim is a low-risk, high-uncertainty bet, I don’t think it falls into the category. The high-uncertainty is courtesy of a tight-lipped regulatory inquiry underway. The risk is provided by the fact that an acquirer with superior knowledge has walked away (perhaps just looking for an escape route), and fines that could be posed by a regulatory body set on sending a message (appendix B). The difference between legitimate operations and illegal manipulation in the eyes of FERC is centred on subjective notions of perspective and motivation. To be comfortable with such risk, one would have to be certain of adequate compliance procedures, proper incentives, and unquestionable integrity amongst Maxim’s leadership team. I cannot make that call, perhaps other investors are more familiar with the company’s culture are able to and take advantage of this opportunity.

The good news is that the market does not seem to be discounting a negative FERC decision scenario. Prior to the announcement of the sales agreement the stock was trading at $3.01, compared to $2.85 now. While I’m hoping for a clean sheet, if the market continues to overlook FERC related risk, investors should be able to pick up shares at an attractive price in any outcome. I would just wait for the final decision from FERC.

Thursday, 6 February 2014

Careful when riding coat-tails

Most of my time when looking at investments is spent rejecting ideas. Personally, I prefer reading other peoples ideas from various blogs, SumZero, VIC, BeyondProxy instead of running screens (notorious coat-tail-rider), so every idea I come across is written from another investors point of view - which has its positives and negatives. The positive is that you learn a lot, there are lots of smart investors willing to share their wisdom - how to look at a certain business, things you should be concerned about. The negative is that every investor has different concerns, a different investment philosophy, and will only provide what they feel is the most relevant information. Doing your own work is crucial, no matter who's tail you plan on riding. Two ideas which I'd been working on recently can serve as good examples:

#1) Comparing Apples vs. Oranges - Imvescor Restaurant Group:
This was an idea initially posted on VIC in June 2013 when the stock was at $1.30, with a $3.30 target (available to guests). More recently a couple of write-ups popped up on SumZero with $4.30 & $4.50 targets (members only), the stock is trading at $1.90, so despite rising +45% over the last six months, it was still of interest. The investment thesis goes something like this:
  1. Franchisor business model - stable earnings with high free cash flow generation.
  2. Strong market share in key markets - #1 position in Atlantic Canada and #2 in Quebec, with 240 total restaurants concentrated in Eastern Canada.
  3. Attractive valuation - trading at ~7.7x EBITDA, whereas comps range from 8.5x to 13.9x. Absolute valuation of 9.9x FCF is also attractive given the low capital intensity.
  4. Catalysts - resumption of dividends, new products, activist investors.
At this point I was pretty excited and started to do some due diligence. 

Being a Canadian and not knowing any of these eastern franchises, my first question was obviously how have these franchises fared over time?

The answer was not great. Overall the top two brands have lost 51 locations out of 222 over the last decade, 47 of these were in their respective dominant market. Over the same period Boston Pizza, previously focused on the West Coast added some 90+ restaurants in Eastern Canada alone. While disappointing, I thought this probably explains the cheapness.

Moving onto cheapness I wanted to answer 3 questions:

1. How does the current valuation compare to its historical valuation? 

Not very cheap, the company's current EV of ~C$110mln is close to its historical peak in 2008. The company does boast a retail division now with ~$4mln in royalties, but has lost 20 odd locations since. Overall EBITDA is pretty close to the 2008 rate of ~$18 mln. But hey, just because it's been cheap in the past doesn't mean its not cheap now.

2. How does it compare with its competitors?

This is where the whole "Apples vs. Oranges" rant comes in. The VIC write-up lists four comps, three of which are unit trust - A&W, Boston Pizza, and Pizza Pizza - the writer did explicitly flag this, but let me continue. What is the problem here? 

The problem is that with Imvescor, you have 3 different business models: i) the good franchising business including retail sales; ii) not so great the company owned restaurants which are acquired from struggling franchisees; and iii) not so great manufacturing operations. All three reports treat all the businesses equally and slap a 10x EBITDA multiple or a 6% dividend yield to get their target prices. This means you're paying $70 mln for the two not so great businesses. To provide some perspective, the 10 company owned restaurants were acquired for $2.5 mln and the company currently has $1.5 mln in manufacturing sales + a recently acquired facility for $4mln. I find it tough to get $70 mln worth of value there. 

3) What is it worth on a sum-of-the-parts basis?

Well lets say we assign a 10x mult. to the royalty business for $130mln, and 4x for the company owned restaurants for $12mln, and 4x for manufacturing, which we will assume does $4mln in EBITDA after recent acquisition, for another $16mln. Adjust for the debt and fully diluted cash and share count, you get $2.53/sh. Still attractive compared to its $1.90 price, but our safety margin is now much narrower than say compared to $4.50 in value. Now you start thinking about the fact that the company's two mature franchises have closed 51 locations over the last decade, the multi-brand strategy is clearly struggling to compete against national franchises, and that competition is actually intensifying - well that margin of safety is pretty much gone. 

Imvescor is cheap, but would I want to hold on to it for 10 years against the competition? Definitely not.

Wednesday, 5 February 2014

The two most useless (useful) investment tenets

Over the last few days, I've been thinking about my ever changing investment philosophy, in an attempt reach some clarity towards my current investment process. There are several schools and sub-schools in investing, and even the term "value investor" can mean a hundred different things. So to properly categorize myself within this maze I started to think about some of the folksy wisdom provided by great investors and two gems came to mind because they were completely meaningless to me when I had just started out investing, and now carry a great deal of influence over my decisions.

"Rule # 1: Never lose money; Rule # 2: Never forget rule # 1. "

When I first came across this advice, I thought well geez... "that's pretty useless, of course I don't want to lose money, but how do I make sure I don't lose money?" 

Now after looking at hundreds of different businesses, my investment process revolves around this vague folksy wisdom (this does not mean I never lose money). Nearly all of my time when looking at an investment is spent on how can I lose money in this investment / what can change in this business going forward? My usual reasons includes I don't understand the business (banks, pharmas, tech, resource based), too much debt, too expensive, too cyclical, too close to its cyclical peak, too big and complicated, and of course too competitive - when you have over 20,000 companies in North America alone, you can be quite liberal in rejecting investments.

Buffett himself has exemplified this philosophy better than anyone else - a 58 year investment career with only 2 negative years is simply mind boggling. Thinking about his investment process of - ultra-long-term time horizon or permanence, high concentration, buying quality, Saint-like patience - all are geared around avoiding losers, not buying multi-baggers although that may be the result, but first and foremost on avoiding losers. Even in his early days of buying cigar-butts and work-out situations, Buffet was doing just fine avoiding losers - in his 1963 memo titled "The Ground Rules", he reported his partnerships total realized gains to loss ratio over its  6-year existence to be "something like 100 to 1". 

"Use your [investing] edge."

Once again, when I first came across this advice I thought, hmm what is my investing edge? Am I smarter? Harder working? Copying smarter people? The first two are debatable.

But once again this advice has become a cornerstone of my thinking. Again let me use Buffett's folksy wisdom to explain - "If you have been in a poker game for a while, and you still don’t know who the patsy is, you’re the patsy." - I'm always looking for a reason why I believe this stock is cheap and why others are not taking advantage. It is very helpful in weeding out ideas. The most common (most important) edge is simply having a longer time horizon than others. But coupled with lets say undercovered companies that institutions can't invest in (too small, post-bankruptcy, spin-offs), misunderstood businesses (M&A, conglomerates), or out of favor industries, the opportunities can be enticing.

Other tenets could include:
"Price is the primary determinant of risk and returns"
"Investing is most intelligent when it is most businesslike."
"Learn from and copy success"

I think those are pretty self-explanatory.

Monday, 27 January 2014

My Investment Thesis on Rain Industries

The depressed valuation of this leveraged, underfollowed, niche market, stable margin, and oligopolistic natured business provides an opportunity for a serial capital compounder. 

Investment Thesis

The investment idea presented in this report is a little known industrial business based out of India with global operations called Rain Industries Limited (“Rain”). What started as an Indian cement producer in the early-70’s, is now a global conglomerate with over US$2 bln in annual revenues. Rain can be split into three primary businesses: petroleum coke calcining (36% of revenues), RÜTGERS’ primary coal tar distillation and chemicals production (58%), and the cement business (7%). The company’s two main products of calcined petroleum coke (CPC) and coal tar pitch (CTP) – combining for ~47% of revenues – are used by aluminum smelters in carbon anode production.
Recent Events. On Oct-21-2012, Rain announced the acquisition of the leading coal tar distiller in Europe called RÜTGERS. The acquisition for a gross enterprise-value of €702 mln (₨59.6 bln) was the company’s second overseas leveraged buyout (LBO), and with it Rain became the largest ‘carbon’ supplier to the aluminum industry globally. The acquisition was completed on Jan-04-2013 and yet for nine months ending Sep-30-2013 Rain has earned ₨10.03/sh versus ₨13.22/sh for the same period in 2012. At the time of the announcement, Rain had a market capitalization of ₨14.9 bln (US$280 mln) and based on 2012 earnings, was trading at a P/E of 3.2x. Currently Rain trades 2.7x 2013E earnings with a market capitalization of ₨12.0 bln (US$195 mln). While a margin squeeze in the company’s calcining business explains most of the earnings compression, a number of factors have contributed to Rain’s depressed valuation, namely: i) despite an acquisition valued at ~4.0x Rain’s market value investors have not seen any earnings accretion to date; ii) investors are worried of the company’s leverage ratios; iii) the aluminum industry is out of favour with aluminum prices falling 25% since Jan-2011; iv) the Indian market is out of favour – in 2013 the BSE Sensex index rose 9% while the Indian Rupee depreciated 12% whipping out any gains for foreign investors; v) the company operates in a niche carbon industry with few publicly traded comps; vi) it is an Indian stock with a market capitalization under US$200 mln removing it from most investment manager’s universe; vii) portfolio managers are wary of fraud in all foreign listed equities; and lastly viii) it is fairly challenging for non-Indian Residents to invest in Indian listed securities. All of these factors combine for an inordinately cheap valuation and attractive risk/reward opportunity.
I believe Rain is a potential “triple play” – essentially you’re buying a quality business, trading at a depressed valuation, and one that is operated by a competent and well-aligned management team – providing several avenues for capital appreciation.
  1. Quality of Business. Rain operates as a market leader in both pet coke calcining and coal tar distilling, which are best described as oligopolistic. Barriers to entry for these businesses include: regional markets created by notable transportation cost, longstanding customer and supplier relationships, strategically located facilities, and trademarks and patents. The carbon business operates on a cost pass-through business model, where the operator earns a stable return for sourcing and processing raw materials. Similarly, both pet coke calcining and coal tar distilling take by-products from crude oil processors’ and steel manufacturers’ and turn them into value-add products for the aluminum and chemicals industry. In an economic downturn Rain is able to offset lower selling price with cheaper raw materials; however the recent period has been exceptionally challenging with aluminum prices falling 25% since Jan-2011 and energy-based raw materials cost remaining relatively flat (green petroleum coke and coal tar). Despite volatility in the aluminum prices, from 2008-2012 the calcining business earned 22-25% EBITDA margin (18% in 2013E) while RÜTGERS has earned 11-12% over the last four years (10% in 2013E), demonstrating the business’s low operating leverage.
  2. Business Value. Over the business cycle, Rain is capable of earning ₨26.80/sh in EPS, US$387 mln in EBITDA, and US$204 mln in unlevered free cash flows per year. With lower selling prices combined with compressed margins in its two main products sold to the aluminum industry, I expect EBITDA to come in at US$267 mln (approximately 23% lower than 2012 inclusive of RÜTGERS). The impact on earnings will be much greater – while Rain has acquired businesses with low operating leverage, the company does employ leverage in its capital structure. My 2013 EPS estimate is ₨13.48/sh (40% lower) compared to the consolidated profits of ₨22.42/sh in 2012 if RÜTGERS earnings were added and adjusted for changes in exchange rates. Rain’s valuation on these depressed earnings is still depressed. Using 2013 numbers Rain trades at a P/E of 2.7x and EV/EBITDA multiple of 5.1x. Using cyclically adjusted earnings and EBITDA, which for simplicity sakes we will assume to be the average over the last five years, Rain trades at a P/E of 1.7x and EV/EBITDA multiple of 4.2x. I believe Rain is worth in the ball park of ₨177/sh or ~4.9x its current share price based on a discounted cash flow valuation approach using normalized earnings and 10% discount rate.
  3. Management Plans and Interest. Rain is operated by a well-aligned management team with a track record of prudent capital allocation. Jagan Mohan Reddy is the CEO of the company co-founded by his father, and overall the Reddy family owns ~40% of Rain Industries providing significant alignment of interest. Management is well aware of its depressed valuation and plans to return capital to shareholders while de-leveraging the corporate structure. From 2007 to 2012 Rain reduced its net-debt from US$728 mln to US$413 while returning 12% of income to shareholders.
The Special Situation. The key catalyst for Rain will be the management’s plan to pursue a U.S. listing of the carbon business (calcining, coal tar distilling, and chemicals) in late 2014. While details of the listing are still up in the air, it creates a special situation in Rain’s corporate structure – creditors have provided the company with ~US$1.3 bln at a cost of ~8%, while the equity currently yields over 70%! It is relatively easy for a small cap, leveraged, and niche industry Indian stock to be mispriced, but a partial U.S. listing of the carbon business (which I believe is worth ~US$1.9 bln) should provide a material re-rating in the valuation and also help de-leverage the company.

Back on the block (blog)

Last year I took an hiatus from blogging as most of it was spent working on the sell-side, which provided several regulatory restrictions and very little time to maintain a blog. Now having learned some of the technical skills required to understand and value a business, I hope to find a home at a value-minded shop where I can do what I love on a daily basis. While my search for a home on the buy-side continues, I will post any interesting investment ideas I come across. 

I've also started to manage money (pro-bono basis) for a couple of friends and a family member and this blog provides an ideal medium of communication with them as well. Since the funds are small and liquidity is not a concern at this point, I will try to update all buy/sell decisions in a timely manner - hopefully my "clients" can also gain some transparency into how their money is being invested.

Results and lessons:
Being based out of Canada and having no particular desire of investing in commodity based businesses, I will use the S&P 500 Index as my general benchmark. Last year was a great year for most equity indices and I'm obviously pleased by a year in which my holdings gained +40% while beating a fast rising market - however the year wasn't without its share of mistakes.

Key mistakes: 
  • Investing in a risk arbitrage situation (fancy word for buying a stock trading below its proposed acquisition price). Last summer I made a purchase of a stock offering 8-16% (tender offer had a range) in this situation despite reading warnings from several great investors on why these situations should be avoided - limited upside, much greater down-side, uncertain timing, and a lot of work for the usual 10-12% reward. I rationalized the purchase with the following: i) extremely cheap valuation - the stock was trading at under 5x EV/EBITDA at its takeout price; ii) stable/non-cyclical business - the company provides a niche equipment rental service to hospitals; and iii) well-aligned management - an activist investor stepped in the year before to replace the company's handsomely paid management team - in fact it was the activist investor acting as the company's Chairman that made the offer. Much to my dismay, two weeks after the initial offer the board rejected the bid citing "too low of a price". A couple of months go by and the stock now traded at 25% below my initial purchase. Since the underlying business did not change, and the valuation became much more attractive, I was happy to purchase shares on the way down while being cognoscente that shares could languish until the company decided to start returning cash or another buy-out offer comes by. Luckily, Mr. Market corrected the disparity between the company's price and value much sooner - shares closed the year at $2.14, with my initial purchase coming at $1.73 and average price of $1.49, I was able to walk away  from this lesson relatively and absolutely scot-free. 
  • Seeing a "special situation" through - last year I invested in my first spin-off - I provided a brief write-up on the situation in my Deans Foods post. This particular spin-off offered a bit of everything - a partial listing, spin-off of a high-growth business (WhiteWave), a residual leveraged-stub (remaining Dean Foods), cyclically depressed earnings, corporate restructuring (Dean Foods had also sold its Morningstar business and was aggressively paying down down), and  the promise of shareholder friendly capital allocation going forward - essentially, no matter what I did I should have made money. I realized a gain of 8% in just under 6 weeks - if I had held onto my position until the remaining spin-co shares were distributed, I would have made 28% in 9 weeks - however I was much more concerned about the "DF Stub" valuation and wasn't able to see the bigger picture transformation that was happening at the company. 
  • I'm not sure how to categorize this next mistake other than "once you find a compelling idea - invest in it", don't be an idiot and wait for your other positions to reach a selling price. Last fall I wrote a report for the annual value investing contest hosted by SumZero, with naturally my most appealing investment idea at the time. However, instead of taking a sizable position I waited for the opportunity to exit one of my other positions. The company received a go-private offer in the following weeks and shares ended the year 62% higher than my initial price write-up price.
Other errors include: a purchase of a competitive and deteriorating business, numerous omissions of decent businesses at great prices (debatable if errors), and my initial over-concentrated portfolio (2 positions). As you might imagine, still having a shirt on my back despite all these mistakes made me quite pleased with the 2013 results, and even more excited about future investments. 

Returns to date: I will continue to post my personal returns on a quarterly basis, other portfolios I manage will track these results extremely closely.