Maxim Power Corp - Attractively Priced, but Regulatory Risk Remains

Full report - https://www.dropbox.com/s/w5m7pxep3a6ql5i/Maxim%20Summary.pdf

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.

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.

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.