A Pair of Cheap, Well-Run California Banks

I have never had great luck finding obvious value in California banks. Nearly without exception, these banks trade at large multiples of earnings and tangible book value. This makes sense. After all, much of the state enjoys a strong economy and good demographic trends. It’s a favorable environment for a bank to call home compared to say, southern Indiana or post-industrial regions of Pennsylvania or Ohio. Still, I do manage to find an interesting Golden State bank now and then. Here are brief looks at two banks, both very successful and trading at undemanding values.

River City Bank (Ticker:RCBC) is the Sacramento area’s largest business-focused bank. The company was founded in 1972 by Jon S. Kelly, a Sacramento broadcasting, telecom, and real estate titan. Mr. Kelly remains the largest shareholder. The bank operates 12 branches in 5 counties and focuses on commercial real estate loans, which make up over 80% of its $1.7 billion loan portfolio. The bank maintains strong capital ratios and has low levels of non-performing assets, leading to a “Superior” rating from Bauer Financial. Like many other business-focused banks, River City Bank enjoys a high proportion of non-interesting-bearing deposits. The bank’s balance sheet exceeds $2 billion with nearly one-quarter of that total invested in government debt securities.

River City’s most impressive accomplishment may be its efficiency. In 2018 and 2017, non-interest expenses were under 40% of net interest income. Without the need for a large branch network in order to service retail accounts, River City can economize on staffing and premises expenses. This has allowed the bank to earn >1% on its assets despite a rather pedestrian net interest margin.

With shares trading in the high $180s, River City Bank has a trailing P/E ratio of just over 10. Tangible book value per share sits at $148 for a price/tangible book ratio of 1.28. Shares trade cheaply because of their extremely low liquidity and the perceived risks of commercial lending compared to traditional lending. River City has a long history of successfully managing these risks, and I expect the bank’s strong balance sheet and high lending standards will help them manage whatever the next down cycle brings.

Headquartered one hundred miles or so west in Santa Rosa is Exchange Bank (Ticker:EXSR). Exchange takes a very different tack, operating as a traditional community bank and lending mainly against single-family houses. Founded in 1890, the bank has had only 8 presidents in its history. Exchange Bank maintains a conservative balance sheet, with tangible equity of $241 million on a $2.5 billion balance sheet. Like River City, Exchange Bank invests heavily in government securities and has a high proportion of non-interest-bearing deposits. Exchange saw its deposits swell last year as customers received insurance settlements from the area’s terrible fires. Deposit levels are now normalizing as homeowners rebuild.

Exchange Bank’s efficiency ratio hovers around 70%. That’s good, even if nowhere near as low as River City’s. However, Exchange also earns a much larger net interest spread, allowing it to generate a healthy return on assets and equity. Exchange Bank also benefits from its profitable trust and investment management group. In October 2018, Exchange purchased First Northern Bank’s trust department.

With shares trading in the mid-$160s, Exchange Bank trades at a trailing P/E ratio of just 7.7. Tangible book value per share sits at $141 for a price/tangible book value ratio of 1.16.

Shares of Exchange are illiquid for a unique reason. Rather than passing shares down to his heirs at his death, Exchange Bank co-founder Frank Doyle established a trust that would own 50.44% of the bank’s shares for the benefit of the community. Today, dividends received by the trust are distributed to the Frank P. Doyle and Polly O’Meara Doyle Scholarship Fund for students attending Santa Rosa Junior College. That works out to $3.8 million annually. What a legacy!

The fact that over half of Exchange Bank’s shares are effectively owned by the community makes a buyout or merger much less likely, which probably contributes to their cheap valuation. That doesn’t mean shares cannot perform well for shareholders. After all, the Hershey Company has a similar ownership structure and shareholders have been quite well-treated over the years.

Both River City and Exchange Bank appear under-valued. River City is the more aggressive of the two and will likely grow its balance sheet and earnings more quickly, but is more sensitive to economic conditions. An environment of falling interest rates and a flat or inverted yield curve will present challenges for both banks.

Alluvial Capital Management, LLC holds shares of Exchange Bank for clients. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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NII Holdings Liquidation – NIHD

I ran across a liquidation scenario that is a rarity for this blog. It’s exchange-listed and relatively liquid! Unfortunately, evaluating the range of potential outcomes involves handicapping some legal outcomes. I consider most ideas with litigation angles beyond my circle of competence. However, I’d still like to present this idea in case it falls within the bailiwick of any of my extremely intelligent readers.

NII Holdings has a not-so-distinguished history as a wireless network operator in Central and South America. The company has always struggled against better-funded competitors with superior product offerings. NII went through the bankruptcy process a few years back, selling Nextel Mexico to an AT&T subsidiary. Now, the company has announced a sale of its remaining Brazilian operating subsidiary to América Móvil. Following the closing of the sale and the settling of certain escrow accounts, the company will liquidate. The implied value per NII Holdings share was $2.59 as of March 18. This figure is only a preliminary estimate and is subject to change due to fluctuations in the BRL/USD exchange rate, actual liquidating expenses, and the outcome of certain ongoing litigation. With shares currently changing hands at $1.74, shares could offer substantial upside if all goes as expected.

Here is a slide from the company’s recent presentation showing the projected sources and uses of cash.

The Nextel Brazil asset sale is fairly straightforward. Provisions in the sale agreement protect NII from losses due to cash burn at Nextel Brazil between now the the closing of the deal. Nextel Brazil does have some BRL-denominated debt which could fluctuate in value between now and then.

NII’s net financial debt is also fairly simple. In my experience, companies err on the conservative side when estimating liquidation costs. Nobody wants to be the subject of a shareholder lawsuit for providing estimates that turn out to be far too rosy.

The Mexico escrow is where things get dicy. This asset relates to the sale of Nextel Mexico to New Cingular Wireless Services, an AT&T company, in 2015. As part of the deal, one-tenth of the purchase price was placed in escrow against potential tax penalties for years prior to the purchase. A few small tax payments were deducted from escrow, and a portion of the escrow holdback was eventually released to NII. However, $106 million of the original escrow balance remains in limbo with New Cingular Wireless refusing to allow its release. New Cingular claims it has the right to maintain the escrow while certain tax items and audits remain open, while NII claims the opposite. The parties are involved in court proceedings over the issue. NII projects a net recovery from escrow of $75 million. They suggest this amount is a conservative projection, though of course the projections depends on a legal outcome in NII’s favor or New Cingular releasing the balance to NII voluntarily.

In addition to uncertainties over the Mexico escrow asset, exchange rate developments, and actual liquidating expenses, timing will have a major impact on the ultimate outcome for NII shareholders. The Nextel Brazil sale will carry an 18-month $30 million escrow holdback. The company expects to be able to distribute between $1.00 and $1.50 per share following the closing of the Nextel Brazil sale, but investors will have to wait a while for the liquidation process to reach its end.

Allow me to present four liquidation scenarios, ranging from optimistic to dreadful.

The Ideal Outcome: The sale of Nextel Brazil closes as planned two months from now at the end of August, 2019. 60 days after that, the company distributes $1.50 per share, or $152 million. Six months from then, New Cingular Wireless agrees to release the entire escrow amount, of which NII receives $75 million. 30 days later, NII distributes another $81 million or $0.80 per share. 18 months following the closing of the sale, the $30 million Nextel Brazil escrow is released. 60 days later, NII shareholders receive the proceeds as a final liquidating payment of $0.30 cents per share.

In this scenario, NII shareholders will have received $2.60 per share over the next 22 months. Total return to shareholders is 49% at a spectacular 92% IRR.

The Realistic Outcome: The sale of Nextel Brazil closes slightly later than planned six months from now at the end of December, 2019. 60 days after that, the company distributes $1.25 per share, or $127 million. Nine months from then, New Cingular Wireless and NII reach a legal settlement and NII receives $50 million from escrow, with another $10 million to be received 12 months later in full satisfaction of the escrow holdback. 30 days later, with liquidation costs running higher than expected, NII distributes another $40 million or $0.40 per share. 18 months following the closing of the sale, the $30 million Nextel Brazil escrow is released. 60 days later, NII shareholders receive the proceeds plus the final piece of the Nextel Mexico escrow as a final liquidating payment of $0.40 cents per share.

In this scenario, NII shareholders will have received $2.05 per share over the next 26 months. Total return to shareholders is 18% at an attractive 16% IRR.

The Unfortunate Outcome: The sale of Nextel Brazil closes far later than planned nine months from now at the end of March, 2020. 60 days after that, the company distributes $1.00 per share, or $101 million. The legal maneuvering over the Nextel Mexico escrow drags on another year and NII finally settles for just $30 million just to be done with the whole thing. Thirty days later, the company distributes $25 million, $0.25 per share. 18 months following the close of the Nextel Brazil sale, the company receives just $20 million from the escrow account, having paid out $10 million in penalties for some dodgy tax returns in previous years. 60 days later, the company pays a final liquidating distribution of $0.20 per share.

In this scenario, NII shareholders will have received $1.45 per share over the next 28 months. Total return to shareholders is -17% at a distressing -13% IRR.

The Disastrous Outcome: The Nextel Brazil deal falls apart and the company remains locked in its dispute with the AT&T subsidiary over the Mexico escrow. Shares fall 50% over the next six months. Another trip through bankruptcy seems likely.

Clearly, a wide variety of outcomes is on the table here. If after some diligence one comes to believe a positive outcome is highly likely, this could be a very attractive scenario. Personally, I simply don’t know enough, nor do I wish to dedicate the time it would take to feel confident in my assessments. If NII’s share price fell to the point where even the pessimistic scenario offered a good return, perhaps that would change.

Regardless, this will be a fun scenario to watch. Let me know if you have any insights to share.

Alluvial Capital Management, LLC does not hold shares of NII Holdings, Inc. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.

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Ricegrowers Limited – Value in This Agricultural “Co-op?”

I’m dropping by the old blog today to provide a quick look at an interesting situation in Australia. In early April, Ricegrowers Limited chose to list its stock on the Australian Stock Exchange for the first time. Ticker: SGLLV. Previously, class B shares traded on the National Stock Exchange of Australia, a somewhat obscure and inaccessible exchange with limited trading volume.

Ricegrowers Limited is the corporate parent of SunRice, a nearly 70 year old producer of many varieties of rice. The company has growing, packaging, and distribution facilities around the world. Historically, Ricegrowers functioned much like an agricultural co-op. Its shares were owned exclusively by rice producers and their affiliates and the company was run primarily to maximize the return to these grower-owners. While technically a corporation and not a cooperative or a mutual, the practical difference was small. With the ASX listing, Ricegrowers has chosen to allow non-affiliates to purchase its shares for the first time. The firm will now function as a truly public corporation and will

Ricegrowers’ financial results show a fundamentally decent business at work. Return on equity has average almost 12% over the last five years. (Averages are critical for agricultural producer like Ricegrowers. The results of any particular year are highly unpredictable due to growing conditions and global market demand and supply.) Ricegrowers does employ a decent amount of leverage, but most of its debt is cheap, seasonal debt used to smooth out the cash flow cycle associated with the annual harvest.

The reasons Ricegrowers intrigues me are two-fold. First, the company trades at a discount to book value despite adequate profitability. At a price of AUD 6.50 per B share, Ricegrowers has a market capitalization of AUD 381 million versus book value attributable to shareholders of AUD 416 million. Nearly all of this book value is tangible. Companies earning their cost of capital and still trading below book value are something of a rarity in today’s markets. Second, Ricegrowers is a company with plans! In conjunction with its ASX listing and removal of ownership restrictions, the company published a guide to its ambitious growth strategy. The company intends to double revenue by 2022, while maintaining a double digit return on capital. The full document is available here, but be warned, it’s quite the tome.

For the first time, investors can access one of Australia’s premiere agricultural companies. They are able to buy the company at a discount to book value at a time when the company expects to achieve significant growth while maintaining profitability.

Alluvial Capital Management, LLC does not hold shares of Ricegrowers Limited. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.

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Alaska Power & Telephone – APTL

Alaska Power & Telephone (“APT”) is a classic OTC Adventures stock. It operates in a geography that is remote to most, in a relatively boring industry, with little chance of entering the limelight any time soon. Despite operational success, a strong balance sheet, and a rising share price, the company remains obscure and ignored. I first profiled APT way back in 2012 when shares changed hands at a mere $17 compared to today’s $60. Practically nobody read OTC Adventures at the time, so let me reintroduce the company.

APT has been in operation since before Alaska even achieved statehood. The company provides electrical power and telephone service to many Alaskan communities, including some extremely remote outposts. APT’s regulated power activities are 75% hydroelectric and 25% fossil fuel. Its telecom activities span traditional regulated exchange activities and non-regulated broadband services. In 2017, revenues from broadband-associated offerings surpassed traditional telecom revenue for the first time.

From the company’s 2017 annual report.

Because APT operates two completely different businesses, it is necessary to evaluate each in order to derive a value for the whole. The power business is the smaller and simpler of APT’s segments, so let’s start there.

In 2012, APT’s power business produced revenues of $20 million, with EBITDA of $8.0 million and EBIT of $4.9 million. In 2017, the segment brought in revenue of $19.9 million, EBITDA of $8.5 million and EBIT of $5.1 million. If there’s a textbook stable business out there, this is it. The power business has nearly no growth potential, but also enjoys practically guaranteed profits. The earnings stream from the power segment is essentially an annuity and should be priced like one. Electric utilities in the lower 48 are valued highly. Anywhere from 12-20x EBIT is common depending on asset types, underlying electricity demand dynamics and the regulatory environment. APT’s power segment probably deserves… less. Alaska’s population is stable at best, particularly in the interior areas APT serves. In other words, the demand for electricity will grow slowly. Combining a lackluster demand picture with the reality of APT’s tiny size makes me think a 10x EBIT multiple is fair. That would put the value of APT’s power operations at $51 million based on 2017 figures. On an EBITDA basis, that’s a 6.0 multiple. Are both measures too conservative for a regulated electric utility? Possibly. But if there’s anything I’ve learned, one must be very careful not to pay too much for a slow-growth/no-growth business. When there’s little or no top-line growth to bail you out, every point of the purchase multiple matters.

The “telephone” part of of APT’s business is both larger and more dynamic. Until recently, APT’s telecom segment was like nearly every other rural telecom: facing a slow erosion of revenue from traditional wireline services and scrambling to make up the losses with unregulated broadband offerings. APT was relatively successful in doing so, but the telecom segment was only moderately profitable and certainly not a growth engine for the company. All of that changed with the FCC’s A-CAM program. This rural infrastructure program has already had a tremendously positive impact on the financials of many rural telcos, and will continue to do so for a decade to come. If you’re unfamiliar, A-CAM is essentially an enormous subsidy that telcos can receive if they commit to extending broadband internet access to nearly the entirety of their service areas, including areas far too sparsely populated or remote to justify service under previous funding mechanisms. Naturally, rolling out this service requires a significant amount of incremental capital expenditure. But the net effect is a dramatic increase in both profits and cash flows for many rural telcos, and APT is one of them.

In 2016, APT’s telephone segment (regulated and unregulated services included) earned revenue of $24.7 million, EBITDA of $9 million, and EBIT of $5.4 million. In 2017 with the addition of the A-CAM subsidy, telecom segment revenue soared to $36.4 million, with EBITDA rising to $15 million and EBIT nearly doubling to $10.3 million. Investors should expect to see elevated capital expenditures in telecom for some time to come, so not all of the increased GAAP profits will fall to free cash flow. However, the great thing about investment in fiber is its longevity. Once in the ground, the expensive part is over. Good quality fiber optics can easily last decades and decades, much longer than copper cable or coaxial fiber. The investment APT makes now in expanding its fiber network will be producing revenue in 2049, long after the investment has been fully depreciated. As the rural telco managers I talk to like to say, fiber is “future-proof.” Even in the coming 5G world, fiber networks will serve as the backbone enabling 5G wireless services.

Well and good, but what’s it worth? Other rural telcos trade at EBITDA multiples of 5-6 depending on the attractiveness of their geographies, their opportunity for profitable investment in fiber, the competitive landscape, and balance sheet strength. I value APT’s telecom segment at the high end of this range. APT is well-situated with little threat of new competitors entering their markets and plenty of rural Alaskan households and communities needing broadband services. Compared to highly leveraged rural telcos like Consolidated Communications or Shenandoah Telecommunications, APT carries little debt. For the twelve trailing months ended September 30, 2018, APT telecom produced EBITDA of $15.4 million. We know that APT will receive an additional ~$800,000 in annual A-CAM funding from the FCC’s recent enhanced offers. So we can call EBITDA $16.2 million. A 6x multiple would value the telecom segment at $97.2 million.

Now to the liabilities. Based on its debt amortization schedule, APT had total debt of $48.2 million at year-end. A large portion of this debt is owed to CoBank, a quasi-governmental bank that lends to rural infrastructure owners and operators. CoBank functions much like a mutual and pays out annual “patronage dividends” to borrowers, effectively reducing their borrowing costs. Because it is able to borrow on such friendly terms, I believe the economic value of APT’s debt is below its stated value. I won’t reproduce it here (gotta leave some work for my very industrious readers), but I created a schedule of APT’s debt obligations and discounted the cash flows assuming a spread of 400 basis points over treasuries for each time period. I arrived at a value of $45.5 million, which seems fair to me. This includes the effects of an interest rate swap struck at 7.62% on the largest portion of APT’s debt. This debt is being amortized rapidly and will be gone in five years. I expect APT will receive a much better rate the next time they approach CoBank.

So $51 million for power, $97.2 million for telecom, less debt of $45.5 million values APT equity at $102.7 million, or $80 per share, 33% higher than today’s prices. Once again, this is conservative. I did not give APT credit for any balance sheet cash, nor the CoBank patronage stock it holds. It’s not difficult to imagine some EBITDA growth in coming years from their fiber roll-out either.

While APT appears cheap on the numbers, investors must be prepared to truly think like owners. Shares are very illiquid, and most are held by company insiders and employees. It’s highly unlikely that a bid for the company will emerge, so you’ve got to trust insiders to run the company well. On the whole, they have stewarded the company well. Management took a detour into empire-building a decade ago with disastrous results, but they appear to have regained their discipline. I am happy to hold APT for the long term.

Alluvial Capital Management, LLC holds shares of Alaska Power and Telephone Company for clients. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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Can Philly Shipyard Turn Around? Oslo:PHLY, OTC:AKRRF

Philly Shipyard has a problem. The company has run out of ships to build. Once it completes its current order for Matson, there are no more orders.

Philly Shipyard is (no surprise) located in Philadelphia. Anybody who’s traveled I-95 through the city may have noticed the company’s facilities to the east.

The shipyard has a storied history, with ocean-going vessels built there starting in 1871. The US Navy was a major customer through most of the 20th century. Unfortunately for the shipyard, the end of the Cold War saw a sharp decline in the need for new vessels and none were built after 1970. The shipyard officially closed in 1991 with the property reverting to the city’s ownership. A long campaign by several stakeholders saw the shipyard gain new life, leased long-term to Norwegian conglomerate Kværner in 2000. Philly Shipyard delivered its first new vessel in over 30 years in 2003. Kværner was subsequently taken over by Aker, which listed a minority stake in Philly Shipyard independently on the Oslo stock exchange in 2007.

The following decade was good for Philly Shipyard. A busy order book allowed the company to report consistent profits and pay large occasional dividends. Philly Shipyard’s customers were domestic shipping companies needing vessels for Jones Act operations in American waters. But shipbuilding is a deeply cyclical industry, and the downswing is here. Facing an indeterminate period of inactivity, Philly Shipyard has instituted layoffs and prepared equipment for long-term storage.

All is not hopeless for Philly Shipyard. The company is in discussions with an undisclosed shipper to construct two new tankers, and is bidding on the contract for the US Maritime Administration’s National Security Multi-Mission Vessels. If the company is successful in winning these bids, better times are ahead. If not, the construction bays will sit idle.

Against this backdrop, it is unsurprising that Philly Shipyard’s shares have fallen to their lowest level in years. At NOK 31, shares are down 85% since cresting at over NOK 200 in 2014. The company now trades at a substantial discount to net current assets.

While its shares trade in NOK, Philly Shipyard reports in US Dollars. At September 30, Philly Shipyard had net current assets of $72.1 million. (In this figure I include restricted cash, which is only restricted as collateral against outstanding debt, and cash to be received from the nearly-complete liquidation of a subsidiary.) Book value is $119.2 million. Philly Shipyard’s market capitalization is NOK 390 million/$45 million. Shares trade at a 38% discount to my adjusted net current asset value, and only 38% of book value, virtually all of which is tangible.

This isn’t quite the complete picture. Philly Shipyard can be expected to operate at a loss and burn cash until it can secure new ship orders. The company is limited in how deeply it can cut employment by provisions in the long-term lease with the city. However, if the shipbuilding cycle bottoms at any point in the next few years and if Philly Shipyard can keep itself afloat until then, shareholders could be richly rewarded when profits return. For context, Philly Shipyard paid dividends totaling three times its current market capitalization between 2014 and 2017. When times are good for Philly Shipyard, they are very good. The question for investors is when and if good times will come around again.

Alluvial Capital Management, LLC does not hold shares of Philly Shipyard ASA. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.

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Left for Dead: Manning & Napier – MN:NYSE

It’s no secret that the active investment management industry has seen better days. Decades of high fees and uninspiring returns have spurred investors to reallocate their dollars to passive index-following strategies. Declining assets under management not only reduces the earnings that active managers collect, but also the multiple at which the market is willing to capitalize those earnings. As the industry continues to struggle, active asset managers have seen their valuations and stock prices decline. And yet, active managers still hold trillions in assets under management. Active strategies aren’t going away any time soon. 

You wouldn’t know that from looking at certain asset managers. The heavy pessimism surrounding the active asset management industry has lead the market to price certain managers as if they will soon cease to exist entirely. A prime example is Manning & Napier, Inc.

By any benchmark, Manning & Napier is an extraordinarily successful manager. Founded in Rochester, New York in 1970, the firm grew its AUM to a whopping $50 billion by 2013. At one point, the firm’s flagship large cap equity fund beat the S&P 500 for 11 years running. M&N went public in 2011 with a slightly unusual structure. Manning & Napier, Inc. owns a minority interest in the underlying management company, Manning & Napier Group, LLC. In 2011, M&N, Inc.’s ownership in the management company was 13.2%. It has since increased to 18.2% as owners of the management company have converted their interests to shares of the public company over time. 

Unfortunately, the IPO represented the high point for Manning & Napier and its investors. Soon after, the performance of the company’s largest and most important funds began to suffer. The redemptions started coming and they haven’t stopped since. From the peak in 2013, AUM has now declined by more than half to $23.1 billion at September 30, 2018. Over the last five years, Manning & Napier shares are down nearly 90%.

Today, M&N appears to be a mere $25 million market cap speck. In truth, the company is a little larger. Remember that M&N owns only 18.2% of the underlying investment manager. On a full ownership basis, the market is valuing the entire manager at $138 million. 

An investment manager with $23.1 billion under management for $138 million. That’s a value of 0.6% of assets under management. That’s low, even for a shrinking company in a despised industry. By way of comparison, Hennessy Advisors is valued at 1.4% of AUM and Silvercrest Asset Management Group is valued at 0.9% of AUM. But that’s not the whole story. Turns out Manning & Napier has a wealth of cash and securities on its balance. The only meaningful liabilities besides normal payables is an $18 million tax liability which will come due over time as the company continues to exchange its shares for additional ownership in the underlying manager. Cash and securities, net of the full tax liability equals $128 million. That makes M&N’s actual market value something close to $10 million. That’s right, $10 million or a mere 4 basis points of AUM buys you $23.1 billion in AUM. 

So what’s the catch? There’s got to be some horrible issue facing Manning & Napier. An SEC action, maybe litigation by former employees? No and no, but the company does have some serious cost issues. With half the AUM it once had, it seems M&N has had difficulty cutting costs to match its new reality. And that has had a terrible effect on operating margins. In 2015, the company earned $129 million in EBIT on revenue of $138 million for an operating margin of 40%. In 2017, EBIT declined to $52 million on revenue of $202 million for a 26% margin. Through the first three quarters of 2018, EBIT has continued to plunge far faster than revenues. 

I understand Manning & Napier’s reluctance to let go of long-time employees and its desire to maintain a robust infrastructure in hopes of a turnaround. But at some point, there must be a reckoning. The last quarter’s EBIT margin dipped to 11%, and it could go negative in the fourth quarter given the market’s path these last few months. Again, for comparison, Hennessy Advisors put up a 45% operating margin this year, and Silverspring did north of 20% this last quarter. Slightly different models, sure. But the point remains there’s no excuse for earning so little on the revenue stream from over $20 billion in AUM. The glory days are over. They may come again, but for now it’s time to tighten the belts a few inches. 

Manning & Napier appears exceptionally cheap, but investors must be comfortable with the risk that the company fails to address its AUM slide or failing that, cannot address its cost issues. On the other hand, solving one or both of these challenges could result in a massive upswing in profits and equity value. 

Alluvial Capital Management, LLC does not hold shares of Manning & Napier Inc, Hennessy Advisors, or Silvercrest Asset Management Group. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.

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Checking In With a Few Ideas

Checking in! Once again, life gets in the way. My wife and I welcomed a baby girl in September. (Everyone is doing very well!) And of course, Alluvial Fund keeps me very busy. But the search for value goes on, and I’d like to share a few interesting companies I’ve happened upon. These are only vignettes, but you may find them intriguing enough for further due diligence.

Societe Marseillaise du Tunnel Prado-Carenage SA – Euronext Paris: SMTPC

I’m a bit of an infrastructure nerd. I’ve always been fascinated by bridges, tunnels, ports, canals, pipelines, transmission assets, the list goes on. Even better when these assets are publically-listed! The grandly named Societe Marseillaise du Tunnel Prado-Carenage SA is a shining example. SMTPC holds the concession on the 2.5km tunnel linking the A50 motorway in Marseille with the A55 motorway. This critical tunnel saves motorists time, allowing them to duck under the ancient, winding streets to the hilly south and east of the city.

SMTPC holds this concession until 2025. The present value of conservatively estimated profits from now to the end of the concession, plus balance sheet net working capital, appears to be substantially higher than SMTPC’s market capitalization. The company pays substantial dividends, yielding 10.7%.

An important question for investors concerns SMTPC’s plans following the end of the concession period. The obvious path for the company would be an orderly liquidation, but perhaps the company has other plans. It could bid on brand new tunnel or bridge concession projects, though these seem to be few in number in France. It could attempt to purchase existing concessions, though they would face serious competition from much larger infrastructure investors like pension funds and insurers.

There is also the question of competition. Apparently, the Prado-Carenage Tunnel is known for high tolls and traffic jams. In October, the long-planned L2 North roadway opened up, allowing drivers a free means of avoiding central Marseille. It remains to be seen just how much revenue this costs SMTPC. Certainly some, but perhaps less than expected if the new roadway quickly becomes over-burdened and slow.

Brickworks Limited – Australian Stock Exchange: BKW

A brick company! What could a boring value investor like more than that? After all, mankind has been using some variety of bricks for several thousand years with no end in sight. Brickworks is a brick manufacturer, but it’s also a lot more. Thanks to a lucky and/or skillful investment made in the late 60s, Brickworks owns a sizable interest in one of Australia’s oldest and most successful holding companies: Washington H. Soul Pattinson. WHSP is listed on the Australian stock exchange under the ticker “SOL.”

Here’s where a dowdy basic manufacturer gets interesting. Brickworks is valued at less than its stake in WHSP. Brickworks’ market capitalization is AUD 2.55 billion, while its 42.72% ownership in WHSP is worth AUD 2.70 billion. Brickworks also has property interests worth more than AUD 500 million, let alone its namesake building products segment. In 2017, the building products segment produced operating income of AUD 76 million. A conservative 6x operating income would value the segment at AUD 456 million.

Based on these very simple estimates, Brickworks appears to be worth at least AUD 3.70 billion, quite a lot more than the company’s value in the market today. Lately, the company has increased its investment in US brick manufacturers. Brickworks sold off some WHSP shares to fund the deals. Despite the share sales, the value of the company’s holdings in WHSP will continue to be by far the largest driver of Brickworks’ value.

Mechanics Bank of Richmond – OTC: MCHB

It’s no secret that I like very high-priced stocks. Not a lot of retail investors are willing to pony up for shares with five digit dollar price, and that results in lower valuation. One such stock is Mechanics Bank of Richmond. Mechanics Bank is a $6 billion institution located in Southern California.

In 2015, Ford Financial Fund purchased a controlling interest in this venerable bank. Ford Financial is run by Gerald J. Ford, an extremely successful investor in banks and other financial services companies. Mr. Ford has a history of stewarding banks to greater profitability and scale before orchestrating a sale at a large premium. This is exactly what will happen to Mechanics, eventually.

Since the takeover, Mechanics has acquired two local competitors and has grown its balance sheet from $3.6 billion to over $6 billion. I don’t know how large Mr. Ford and his lieutenants expect to grow Mechanics before seeking an acquirer, but I do know that they have made progress and will make more.

US banks with $5-10 billion balance sheets trade have a median valuation of 1.3x book value. Mechanics trades at about 1.05x book value. A sale at even 1.5x book value would fetch over $45,000 per share. Whether a sale happens in 2019 or it takes a few more years, I fully expect to earn a healthy profit on shares of Mechanics Bank.

Alluvial Capital Management, LLC holds shares of Mechanics Bank of Richmond for clients. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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Southern Bancshares – SBNC

Southern BancShares is my favorite type of company. The firm is secretive, allergic to self-promotion, strongly profitable, and loves to return capital to shareholders. Just as important, the company is dedicated to making prudent investments and sensible acquisitions and expansion.

Southern BancShares was founded in 1910 as the Bank of Mount Olive in Mount Olive, North Carolina. The bank has expanded throughout eastern and coastal North Carolina and into Virginia’s Hampton Roads metro. Over the last 20 years, the company grew its tangible book value per share at an 11% annual rate and repurchased 32% of its shares outstanding along the way.

Somewhere along the way, Southern BancShares picked up a meaningful stake in a related bank: First Citizens BancShares. It’s no coincidence. A look at the board of directors and top holders of each company reveals many of the same names. These companies are closely-related and have been since their founding. By any measure, First Citizens BancShares is a successful mid-sized bank. Over the last 20 years, the company grew its book value per share fivefold while building its balance sheet from $9 billion to $35 billion. First Citizens has long been a voracious acquirer of small banks, and benefited from its locations in high-growth areas with good demographics. The company now operates bank subsidiaries in 19 states and is in the midst of acquiring Capital Commerce Bancorp. Because of its growth efforts, First Citizens has come to dwarf Southern BancShares. First Citizens is NASDAQ-listed.

At year-end, Southern held 204,463 First Citizens Class A shares and 22,619 First Citizens Class B shares. Together, these shares are worth $106 million. Not shabby! With just 81,223 shares of Southern BancShares stock outstanding, each share of Southern BancShares represents ownership of 2.52 First Citizens Class A shares and 0.28 First Citizens Class B shares. That’s total value of $1,300 per Southern BancShares share.

Southern BancShares stock is illiquid and the bid/ask spread is often wide. But at a recent price of $3,600, the look-through value of the First Citizens stock that Southern owns makes up 36% of its market capitalization.

The remaining $2,300 of the share price that isn’t covered by First Citizens stock works out to $187 million in equity market value. Adjusted for the tax-effected value of its First Citizens stock, Southern BancShares’ tangible common equity is $172 million. So in essence, an investment in Southern BancShares stock at the current share prices values standalone Southern BancShares at 1.1x tangible book value and a current P/E of ~7.5x.

That’s one way of seeing things. The other way is to estimate a fair value for Southern BancShares’ operations, then to see what we’re paying for First Citizens. I think 1.7x tangible book value is a very conservative value to apply to Southern. This works out to only 11.6x current earnings. At this valuation, Southern’s own operations would be worth….$3,600. That’s the entire current market capitalization, meaning investors get First Citizens for free!

Just as a check, we can look at the valuation on a look through basis. First, earnings. Southern BancShares’ own operations should produce about $310 per share in earnings this year. First Citizens should earn about $31 per share in 2018. That would add $87 per share to Southern’s earnings if First Citizens were treated as an equity investment. This totals to $397 per share, giving us an estimated current P/E of 9.1x. On a tangible book value basis, remember that Southern’s banking operations have tangible equity of $172 million. On a look-through basis, the owned First Citizens shares add $65 million. That totals $237 million. Southern BancShares’ market capitalization of $292 million yield a price-to-tangible book ratio of 1.2x.

I’m not big on relative valuations, but they do provide helpful insight into market expectations. Right now, US banks with balance sheets from $10-50 billion trade at a median price-to-tangible book ratio of 2.2x and a median current P/E of 17.5x. Banks with $1-10 billion balance sheets trade at 1.8x tangible equity and with a P/E of 17.0x. No matter how you categorize it, Southern BancShares looks cheap.

The usual stipulations apply. Southern BancShares stock is extremely illiquid and the company is closely-held. What insiders want, they will get. The company’s bank operations are also fairly geographically concentrated (though First Citizens is national in scope) and a downturn in the North Carolina economy would sting. Investors in Southern BancShares should not expect short-term fireworks and must be prepared to hold on the very long term.

Alluvial Capital Management, LLC holds shares of Southern BancShares, Inc. for clients. Alluvial Capital Management, LLC does not hold shares of First Citizens BancShares, Inc. for clients. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

 

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Aerocentury Internalizes Management – ACY

I have another interesting idea in the aircraft leasing industry: Aerocentury Corp.

Aerocentury is a tiny aircraft lessor headquartered in California. The company owns 25 aircraft, all smaller regional jets and turboprops, plus one engine. Aerocentury focuses on aircraft worth $10-25 million and attempts to lease them for periods of 3-7 years. Lessees tend to be small regional airlines worldwide.

Aerocentury’s operating history is lackluster. Over its 21 year corporate existence, the company has always struggled to earn its cost of capital. The company’s profits have been wildly inconsistent year-to-year, with periods of strong results followed by mis-steps and losses. The company has occasionally had leases go bad, and recently suffered after buying a few aircraft for which demand proved elusive. But the biggest reason that Aerocentury has always struggled to earn sufficient profits is its relationship with Jetfleet Management Corp. Jetfleet is responsible for managing leasing activities for Aerocentury, and gets paid handsomely for the task. From 2013 through 2016, management fees paid to Jetfleet amounted to nearly 28% of Aerocentury’s total operating lease income. Jetfleet is controlled by Aerocentury’s largest shareholder.

This onerous external management structure and the resulting depressed profitability is likely the reason that Aerocentury trades at such a gigantic discount to its asset value. At $16.80, Aerocentury is priced at 50% of book value. (And this is after a pretty decent upward move in the stock. For much of 2017 and before, shares traded at under 35% of book value.) However, the company is in the process of unwinding this structure.

Aerocentury is in the process of buying Jetfleet and fully internalizing its management. The company will pay Jetfleet’s owners $3.5 million in cash and 129,286 shares of Aerocentury stock. This is a good deal for Aerocentury. At $16.80, the purchase price for Jetfleet works out to $5.7 million, which is 3.4x Jetfleet’s estimated 2017 operating income. The company estimates Jetfleet’s 2019 operating income will be $2.0 million. Assuming a 30% tax rate for Aerocentury, this would add 91 cents per share to Aerocentury’s annual net income. The resulting increase in profitability might convince investors to value Aerocentury shares closer to book value.

The successful completion of the acquisition is not in question with Jetfleet’s controlling shareholder in favor. The transaction has taken a little longer than expected. Aerocentury had not expected to bring the issue to a shareholder vote, but was ultimately required to do so by law. That accomplished, the acquisition should be completed this year. Integration risk is minimal, given the existing close relationship.

Internalizing management will unquestionably benefit Aerocentury’s profits and clean up the company’s principal-agency conflicts. However, investors should still view the company with a skeptical eye given its history of poor results (even after adjusting for Jetfleet’s fees) and its operating model. As I mentioned before, Aerocentury’s lessees are regional airlines worldwide. Many of these are not “investment-grade” carriers and there is a risk of non-performance. The airline industry is cyclical and these carriers are at the end of the whip, feeling the effects of fuel costs, local recessions, and other headwinds most acutely. Aerocentury is also feeling the effects of rising interest rates, paying much more than before to finance its fleet. The company lends long and borrows short, so spreads will be compressed until leases reprice at the end of their terms.

Aerocentury is ultimately not for me, but more enterprising readers may find the company’s shares too cheap to resist.

Alluvial Capital Management, LLC does not hold shares of Aerocentury Corp. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.

 

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Doric Nimrod Air One – DNA:LN

Remember OTCAdventures? I’m still here, just very busy with Alluvial Fund, LP and all the fun of a young family. I found an intriguing investment idea, but be warned: I don’t know how to buy this. Futhermore, I cannot provide any advice on the tax implications of owning this investment or related securities. But here it is: Doric Nimrod Air One. “DNA One” is a Guernsey-domiciled closed-end fund that trades on the London Stock Exchange.

This fancifully-named fund could hardly be simpler. It was formed in 2010 for one purpose:  to acquire a single aircraft, lease the aircraft to an airline for an extended period of time, then to sell the aircraft at the conclusion of the lease and liquidate. Payments received over the course of the lease would be used to amortize acquisition-related debt and to pay an investors a steady quarterly distribution. DNA One acquired an Airbus A380-681.

The A-380 is the world’s largest passenger aircraft, able to handle extremely long flights. Over 200 of these aircraft have been produced and delivered, with many more in production. The UAE’s “Emirates” is the largest operator of these aircraft, with over 100 in its fleet. True to form, DNA One leased its A380 to Emirates for a period of 12 years.

The original debt associated with the purchase of the A380 was $122 million. In the seven years since the acquisition, DNA One has reduced the balance of that debt to $43 million. Meanwhile, the fund has paid a quarterly distribution to investors of 2.25 pence. The lease with Emirates is scheduled to terminate in December 2022, after which DNA One will sell its aircraft. Emirates has the right to purchase the aircraft at fair market value. If Emirates declines to purchase the aircraft, the fund will put the A380 up for sale in the general market. The global market for modern wide-body passenger aircraft is liquid, so I don’t anticipate any issues in achieving a quick sale.

So the question becomes “How much can investors expect to receive as a liquidating payment?” Fortunately, the fund helps us out with that. The fund orders an annual appraisal of its aircraft from multiple appraisers and provides this information to investors. As of March 31, the average estimated value of the A380 at lease expiration was $101 million.

Using the $101 million figure and June 30 exchange rates, the fund projects a capital return of 178 pence per share when the aircraft is sold at the end of its lease. Between now and then, investors will continue to receive 2.25 pence each quarter. Shares of DNA One recently closed at 100.50 pence, indicating potentially excellent return potential. If the quarterly income and capital return estimates hold true, investors purchasing shares today stand to earn an IRR of a little more than 21% between now and the end of 2022. The fund spells things out in its quarterly report.

Now for a look at what could go wrong. The biggest risk Doric Nimrod Air One faces is the possibility that its aircraft could actually be worth substantially less in 2022. Aircraft values are affected by supply and demand, which in turn is driven by the activity of airlines and the pace of production and technological advances by aircraft producers. A look at the trend in recent appraisals does show a downward trend. In 2017, appraisers valued the A380 at $104 million. In 2016 the figure was $107 million. A 10% decline in aircraft value from the current $101 million estimate wold reduce liquidation value for shareholders by 18 pence. Still, it would require a very large decline in the value of DNA One’s A380 to create a truly adverse scenario for investors. By my calculations, the value of the aircraft at lease expiration would have to plunge 40% to $60 million for investors’ IRR to fall to 10%.

Then there is counter-party risk. Let’s not forget that DNA One has only a single asset, and a single lessee. If Emirates encountered financial difficulty, the stream of lease payments could be interrupted and suddenly DNA One would find itself with no revenue and bills to pay. However, Emirates has long enjoyed strong profitability and the firm support of the UAE’s ruling family, so I consider the airline a high quality counter-party. There is also the fact an early lease termination could even be a good thing for DNA One’s shareholders. Even after paying off the remaining acquisition debt, the fund’s net asset value would be substantially in excess of its trading price and shareholders could receive a large payment several years earlier than planned.

So why does DNA One appear so cheap? My guess is the usual suspects: size and illiquidity. The fund’s market capitalization is only £42.7 million and less than £20,000 worth of shares change hands daily. I also suspect that only a small sub-set of investors is willing or able to invest in a Guernsey-domiciled closed-end fund.

Could be an opportunity.

I should also note there are two other related funds: Doric Nimrod Air Two and Doric Nimrod Air Three. Each is substantially larger than DNA One, more diversified, and has a longer time remaining in its aircraft leases. DNA Two appears to offer an IRR of 16% at current exchange rates and appraisals, while DNA Three offers 14%. Each fund owns the same type of aircraft and leases mainly to Emirates, so the huge divergence in prospective returns is a little strange to me even with Doric Nimrod Air One’s tiny size and asset base.

I would really like to hear your thoughts!

Note: I have already received some good comments highlighting the difficulty that the A380 may face down the line given its limited acceptance from major carriers. Residual value is a more serious concern than I had indicated in this blog post. That’s what’s fun about investing: the learning.

Alluvial Capital Management, LLC does not hold shares of Doric Nimrod Air One, Two, or Three. Alluvial Capital Management, LLC may hold any securities mentioned on this blog and may buy or sell these securities at any time. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Alluvial Capital Management, LLC manages a value investing partnership, Alluvial Fund, LP. If you are a qualified investor and would like more information, please contact us at info@alluvialcapital.com or visit alluvial.capital.

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