Value Investors, Value Collectors

I’ll be in Omaha May 5-7 for the Berkshire Hathaway shareholders’ meeting and the Markel brunch. I have a busy schedule, but it would be great to meet up with any readers who will be in attendance. E-mail me at dave.waters@alluvialcapital.com.

In my five years of writing on OTCAdventures, I have had the pleasure of interacting with hundreds of investors in micro-cap stocks and other market niches. I have found that people have different motivations for investing in these companies. Some simply want to make a lot of money. Others get a measure of pride and satisfaction out of owning things that few others do and discovering new treasures to add to their hoard. These I’ll dub “Collectors.” Collectors desire a good return, but delight in businesses that are unique in some way, or have some historical cachet.

I am one of these. I derive a great deal of satisfaction from owning the truly rare and unusual. Century-old community banks, the leftover husks of former corporate dynasties, industry pioneers now occupying some sleepy niche. Problem is, many of these “Collector Edition” securities are simply not good investments. Either the economics of the business are too challenging or management is out-matched or self-serving. Consequently, these are not often securities I buy for Alluvial’s clients and partners. But personally, I really enjoy owning stocks  like Ohio Art Company, which until recently was the owner of Etch-a-Sketch. Or St. John Knits, the venerable designer of  apparel for wealthy and powerful women.

One of these unusual companies I have never seen being discussed anywhere is Massachusetts Business Development Corp. I have been a shareholder for several years. “MBDC” is a strange quasi-governmental organization dedicated to providing business financing and venture capital in the New England region. MBDC is not government-owned, but it is very much government-supported via various lending and tax incentive programs. Founded in 1953, the company is the nation’s oldest Business Development Company. Over the course of its existence, MBDC has invested over $1 billion in small companies and startups, creating untold wealth for the economies of Massachusetts and the neighboring states. MBDC invests directly in companies, providing the full spectrum of financing from senior and mezzanine debt to working capital factoring or equity. MBDC also manages a handful of investment funds and invests in these funds.

MBDC operates as a sort of co-op. While shareholders are the nominal owners of the company, the true power rests with the company’s members, a large group of New England banks and insurers who provide the company with capital to deploy. There are 165,382 MBDC common shares outstanding, each with one vote. But, members receive 1 vote for every $1,000 of capital loaned to MBDC. There is presently $56 million in capital loaned to MBDC by members, resulting in 56,000 votes for those members. Shareholders are simply along for the ride.

The company is consistently profitable and does pay a small dividend. But one might expect that with the company’s economic growth mandate, it is not a profit maximizer. One would be correct. MBDC’s three year average return on equity is around 6%. At year-end, Massachusetts Business Development Corp.’s balance sheet reached $77 million, up from $67 million in 2014. The company has been focused on deploying more capital in support of economic growth in its service region. Book equity is currently $10.3 million, which makes the company appear highly leveraged. But remember that nearly all of MBDC’s financing is provided by member banks and insurers, at a very low cost. At year-end, the company’s cost of debt was just 1.4%, and the company had borrowing capacity of an additional $163 million. MBDC does experience loan losses typical for an investor in venture-stage and small enterprises, but these losses are easily surpassed by the loan fee income and investment management income the company generates.

Liquidity is extremely poor for MBDC shares, and the bid/ask spread frequently suggests no reasonable two-way market exists. At the most recent trade of $28, MBDC trades at a price to book ratio of 45% and a P/E of 8.2. I am not suggesting this is cheap. Remember that shareholders have effectively zero control over the company and should not expect any sort of meaningful dividend, share repurchases, a buyout or other value catalyzing event. I expect that MBDC will go about executing its mandate, not seeking to enrich a tiny number of voiceless shareholders. The only way I can foresee shareholders doing very well is if the business is for some reason placed into run-off and eventually liquidated. How could that happen? I suppose that like the controversy over the federally-chartered Export-Import Bank, conservative politicians could seek to nix MBDC in the name of opposing “crony capitalism.” But frankly, that’s pretty unlikely in New England. It’s much more likely that MBDC continues to operate for decades, and remains nothing more than a little oddity in my portfolio. And that is fine with me.

I personally own shares of Massachusetts Business Development Corp. I may buy or sell shares of MBDC at any time.

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First National of Nebraska – FINN

I have long held that a prime hunting ground for value is in very high-priced stocks, especially those that are unlisted or trade in foreign markets. For whatever reason, investor appetite for shares really falls off once the price eclipses $1,000, especially for illiquid stocks. I suspect the wide bid/ask that often accompanies these shares is also a contributor. Those willing and able to purchase these high-priced shares may walk away with a bargain.

A textbook example of this phenomenon is First National of Nebraska, a large and well-run bank that nonetheless trades at a deep discount to the valuations its peers command.

Since this blog focuses on micro-cap stocks, one might assume that I mean “large” in a relative sense, as in a balance sheet of one billion dollars or so. But First National is a truly large bank holding company, with a balance sheet of $19 billion. Fewer than 50 other public US banks are larger. But you’ll never hear about First National of Nebraska’s shares on CNBC, because they have an eye-popping price tag of $7,500. A typical day’s trading volume is in the single digits, so it’s not exactly easy to acquire a huge position.

First National is well-run in the sense that it consistently generates a return on assets in excess of 1.0%, and a return on equity of 10-11%. The company maintains a strong capital position with common equity to total assets of >10%, a much lower leverage ratio than the company employed before the crisis. Speaking of the crisis, First National never had one. Profits suffered in 2008 and 2009, but the bank never recorded an annual loss. The recession was only a temporary setback in the bank’s continued expansion.

First National has 101 branches in seven states. Please excuse the poor image quality of the graphic I borrowed from the company’s annual report I received last week.

Some banks focus on residential mortgages, others on commercial real estate, others on agricultural or development loans. First National of Nebraska has carved out a very profitable niche in credit card lending. Thousands of different businesses and non-profits offer their own branded credit cards to customers and members. First National is the entity actually making these revolving unsecured consumer loans. First National counts Best Western and Ducks Unlimited among its customers, and has a nearly $6 billion portfolio of credit card loans. Credit card loans are riskier than other types of lending, but the bank has large reserves against expected loan losses and has proven itself a responsible lender in the sector. Credit card loans make up 43% of First National’s loan book. Commercial loans, real estate and otherwise, make up 29%. Agricultural loans are 11%, residential real estate 10%, and “other” 7%.

First National has a long history of steady if not spectacular growth. Since 1997, the bank’s balance sheet expanded at an annual rate of 4.3%. Loans grew at the same pace, while deposits expanded at 4.7% annually. Profits grew at a 5.4% rate. Profit growth on a per share basis has been higher recently, growing at 8% since 2012.

Despite its healthy balance sheet, good profitability and attractive niche business, First National of Nebraska trades at a large discount to other banks of similar size and quality. I generated a list of publicly-traded banks with $10-30 billion balance sheets and a five year average return on equity of at least 8%. I may have missed a few peers, but this exercise is to prove a point, not create academic-quality data.

The entire peer group trades at an average price-to-book ratio of 1.8 and a P/E ratio of 19.8. First National’s closest competitors in terms of average historical ROE trade slightly higher, at a P/BV of 1.9 and a P/E of 20.5. Whichever set of banks we look at, First National of Nebraska is far cheaper at just 1.1x book value and a P/E of 10.4.

Perhaps some of this discount is justifiable. First National may carry more risk than other banks in its size range because of its exposure to credit card and agricultural loans. Credit card loans are uncollateralized and agricultural is highly cyclical. And yet, First National of Nebraska remained profitable in the crisis when many traditional residential real estate lenders failed. Or, perhaps the market is concerned that First National may lose some of its credit card relationships. They did lose a large relationship in 2016. Maybe the market doesn’t believe that First National will benefit from rising rates the way its peers will.

However, I believe that nearly all of the valuation discount is due to First National of Nebraska’s lofty share price and minimal trading volume. This presents opportunity for long-term investors who care little about the day to day fluctuations and much about the long-term performance of the underlying business. Naively assuming the bank can earn its long-term return on equity of 11.0%, First National could earn almost $790 per share in 2017, for a forward P/E of 9.6. Of course, who knows what this year holds. A recession could arrive, or expected higher interests rates could fail to materialize. But I am sure that long-term holders of First National of Nebraska will be richly rewarded.

Alluvial Capital Management, LLC holds shares of First National of Nebraska, Inc. Alluvial may buy or sell shares of First National of Nebraska, Inc. at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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Parks! America – PRKA

As someone who traffics in the obscure and the unusual, I am always particularly interested when I happen across a company with a unique business model. Often, the company is the only publicly-traded entity in its line of business. As far as I can tell, this is the case with Parks! America Inc. Parks! America operates wildlife parks in Pine Mountain, Georgia and Stafford, Missouri under the “Wild Animal Safari” brand. These are exactly as they sound, enclosed areas where exciting non-native wildlife roams for visitors to observe. At both locations, visitors can observe dozens of species in a natural(ish) setting. Visitors can feed some of the more amiable species. I would imagine this does not include the wolves and tigers.

Now, I know what you might be thinking, and it’s the same thing that occurred to me when I first ran across the company. How do I know this isn’t some shifty carnival-type operation where sad-eyed, underfed wild creatures  pace in circles in tumbledown enclosures? While I have not visited either of Parks! America’s properties in person, visitor reviews tell a different story. Tripadvisor reviews for both the Georgia and Missouri properties are overwhelmingly positive, with hundreds of reviewers speaking of their good experiences, especially families with young children.

Financially speaking, running a wildlife park appears to be a surprisingly good business. In 2016, Parks! America reported an operating margin of 28% and a return on tangible equity of 20%, adjusted for a one-time tax benefit. But these figures don’t tell the whole story. For several years now, Parks! America’s Georgia property has been a standout, strongly profitable and with growing revenues. However, the company’s Missouri property has struggled. Wild Animal Safari in Missouri has only recently achieved an operating profit for the first time since 2012. Below is a breakdown of yearly results at each property.

So what we really have in Parks! America is a company with one astonishingly profitable and successful property, and one struggling property. To me, that spells upside potential. If Parks! America is able to build on the small amount of positive momentum their Missouri property has generated, a sharp increase in profits could result. Alternatively, it the company chose to pack it in and sell the property, significant capital could be released.

For the trailing twelve months, Parks! America’s wildlife parks produced $2.29 million in operating income. Corporate expenses were $0.66 million, leaving company EBIT of $1.63 million. Annualized interest expense in the most recent quarter was $0.20 million, leaving pre-tax income of $1.43 million. Parks! America is not a taxpayer for the moment as it works off its $1.9 million federal NOL. Georgia state corporate income tax is 6%, giving pro forma trailing net income of $1.34 million, or 1.8 cents per share on a market cap of $9.7 million. Oh, did I forget to mention that Parks! America is tiny? Indeed, it’s one of the smallest public companies I have run across that actually generates attractive margins and cash flow.

At a market cap of $9.7 million, Parks! America trades at 7.2x trailing earnings. These earnings will likely rise substantially in fiscal 2017 if the company can again increase visitor numbers at its Georgia property and increase margins at its Missouri property.

Parks! America does carry debt, but the terms are generous compared to the usurious rates that most other companies this size must pay. In 2013, the company secured a 20-year loan from a local Georgia bank, secured by substantially all the company’s assets. The loan bears interest at prime plus 2.50%, currently 5.75%. Principal amortization requirements are minimal, so the company enjoys a lot of freedom to deploy its cash flows as it sees fit.

For the trailing twelve months, Parks! produced operating cash flow of $1.34 million. After capex of $0.43 million and principal repayments on debt of $0.12 million, the company produced $0.79 million in true free cash flow. For now, that cash sits on the balance sheet. Assuming the company’s profitability remains strong, the biggest question for me is what the company will ultimately decide to do with all the cash they will generate. Will they build another park? This could be lucrative, but also potentially risky if the park runs into the same troubles the Missouri property has faced. Perhaps they’ll begin paying dividends. A management buyout is also a possibility. Insiders control about 55% of the company’s shares, and it wouldn’t take a lot of capital to make an offer to the minority shareholders. Including other major holders, only about 31% of the company’s shares are freely floating.

Readers looking to do further research on Parks! America should be aware that this company is extremely small and its shares are very illiquid. I own a very small stake, which took me months to accumulate. And as usual, it’s far easier to buy into these tiny companies than it is to sell out of them. Shares of Parks! America should be considered a very long term investment.

Alluvial Capital Management, LLC holds shares of Parks! America. Alluvial may buy or sell shares of Parks! America at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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A Post-Mortem on Armanino Foods – AMNF

A blog reader e-mailed me this weekend, asking if I had ever reflected on why I never bought Armanino Foods of Distinction. This reader (who happens to have a quality blog himself) rightly noted Armanino’s many attractive characteristics. The answer is yes. I have asked myself why I never bought any Armanino. I’ve missed out on a nice return on what should have been a slam dunk investment. I had reasons, some good, some less so, and hopefully examining them publicly will benefit me in my future efforts.

I originally wrote about Armanino way back in 2012. Honestly, I have a tough time making myself read through posts from that far back. I’ve come a long way as an investor in the interim! But even then, I pointed out some qualities that made Armanino shares uniquely attractive. Chiefly, the business was astonishingly profitable. The humble purveyor of frozen pesto was producing nearly one dollar of EBIT for every dollar of capital invested, a feat that vanishingly few companies can match. This excellent capital efficiency enabled the company to grow at a rapid clip without dedicating meaningful additional capital to operations. In fact, the company had paid out more than its net income in dividends for several years running, yet managed to grow its top line at a high single-digits rate. Operating income grew even more quickly as operating leverage kicked in. Companies with excellent returns on capital and good growth rates typically and justifiably trade at lofty multiples, but Armanino traded at just 7x operating income at the time of my writing.

So, what made me hold back? Anchoring bias is probably the number one factor. The first time I ever looked at Armanino, shares were trading at between 50 and 60 cents. They were just under a dollar when I wrote. But even though everything about the company screamed “buy!”, something in my mind told me that since the stock had already nearly doubled, it was no longer cheap. Let that be a reminder to us all. A stock that has doubled is not necessarily expensive. Likewise, a stock that has been cut in half is not necessarily cheap.

A second reason was my concern over the company’s competitive positioning. After all, Armanino was and is extremely tiny, and sells its products into an intensely competitive industry. Hundreds of companies are jockeying constantly for shelf space in supermarkets and bulk stores. Many of these companies have annual marketing budgets that exceed Armanino’s revenues. If only one or two decided to compete in frozen Italian foods and/or pesto, Armanino could see its margins get crushed in short order. However, it appears I under-estimated the reputation and loyalty that Armanino commands with its customers. Combined with the fact that Armanino’s products are relatively niche items, larger operators have decided not to attempt to compete in the space, and Armanino’s sales and revenues have continued their upward trend.

Finally, I was concerned that Armanino’s growth would eventually put a strain on its manufacturing capabilities. Both then and now, Armanino creates its products in a single leased factory in Hayward, California. If Armanino’s growth pushed the limits of that factory’s capacity, I feared the company would be forced to undertake significant capex for expansion or forego pursuing additional growth. The possibility of a large deferred capex liability seemed material for a company that had been distributing over 100% of its earnings to shareholders.

So there it is, one intellectual blind spot and two reasonable concerns that perhaps could have been overcome with some deeper research and better understanding. There’s nothing I can do about the missed opportunity except strive to avoid the same bias going forward, and strengthen my analytical capabilities. That’s what serious investors do, try to end each day a little smarter and wiser than we were that morning.

What about now? Does Armanino offer good value today? Armanino shares trade at 11.0x trailing operating income and roughly 16x earnings net of excess cash. Free cash flow has been compressed by increased capital expenditures (there’s that long-awaited expansion spending!) and an increased working capital need. But revenue growth remains healthy, and operating margins are robust, hovering around 18%. By all indications, Armanino shares are somewhat cheap, assuming that 5-10% annual revenue growth continues. Not the bargain they were in 2012, but still likely to provide nice returns for long-term holders. The company is close to paying off the last of its debt, which will free up more cash flow for investment or for returning to shareholders. And yet, I still see a few issues that I would need to understand better before considering an investment in Armanino.

First, it appears that operating margins have plateaued. Since sitting 18% in 2013, Armanino’s operating margins have meandered between 18% and 19%, this after a long stretch where operating margins increased nearly every year. Has Armanino finally reached the limits of its operating leverage? Many small firms achieve remarkable increases in operating margins as their scale increases, but maturity means that future growth in earnings depends on top-line growth and not on better economizing of fixed costs.

And second, some data suggest that Armanino is finding itself competing more on price than it once did. The company very helpfully discloses both gross sales and the net amount received by the company after discounts, slotting fees, and promotional costs. Between 2006 and 2011, the net amount of sales received by Armanino averaged 87.0% and never dipped below 86.4%. But this figure has been trending downward in recent years. For the trailing twelve months, Armanino received 84.3% of gross sales. This is not necessarily a sign of trouble, though it is worth watching. Armanino could be choosing to implement a different pricing strategy, listing its products at a higher sticker cost but more frequently offering discounts and promotions. Or it could be intentionally chasing market share.

I have yet to reach a final assessment of these factors. I don’t feel comfortable buying Armanino without a better understanding of what is driving each data point. Armanino is no longer trading at a single-digit multiple of earnings or EBIT, so there is less room for error if either of these factors indicates a negative business trend forming. So for now I sit on the sidelines, hoping only to learn.

Alluvial Capital Management, LLC does not hold shares of Armanino Foods of Distinction for client accounts. Alluvial may buy or sell Armanino Foods of Distinction shares at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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Steel Excel is an Attractive Special Situation – SXCL

Shares of Steel Excel are trading well below the value of the merger consideration they will receive when the company is taken over by its majority owner, Steel Partners LP.

On December 7, Steel Partners announced an agreement to acquire the 36% of Steel Excel that it does not own in return for preferred units of Steel Partners LP. The units would carry a 6.0% coupon and mature in nine years. Steel Excel shareholders would receive $17.80 in Steel Partners LP preferred units per share. Evidently, the deal was not acceptable to one of Steel Excel’s major shareholders, GAMCO. After discussions with GAMCO, Steel Partners unveiled an amended merger agreement on December 23. The preferred units’ distribution would now be cumulative, and Steel Partners agreed to offer to redeem at least 20% of the preferred units on a pro rata basis in cash within three years of issuance. Steel Partners also agreed to seek an NYSE listing for the preferred units.

Following the announcement, shares of Steel Excel scarcely budged, though the amended terms offered much better value for Steel Excel shareholders. Specifically, the fact that 20% of the preferred units will be redeemed within three years reduces both the effective maturity and the credit risk of the preferred units.

Modeling the implied IRR of Steel Excel shares is a simple matter. When converted into Steel Partners preferred units, holders will receive $1.07 in dividends per year and will have the option of redeeming 20% of their preferred units some time in the first three years after the merger closes. Assuming Steel Partners waits the full three years to redeem units for cash, the IRR for purchasers of Steel Excel shares at $14.75 is 9.3%. Earlier redemption would result in a higher IRR.

9.3% is a generous return for these Steel Partners LP obligations. Though the preferred units are junior to all of Steel Partners’ other obligations, the holding company is quite well-capitalized. At September 30, Steel Partners LP held cash and investments of over $97 million against debt of $57 million. Upon taking full ownership of Steel Excel, Steel Partners will assume direct ownership of another $122 million in net cash and securities. The full face value of the Steel Partners LP preferred units in issuance as the result of the merger transaction will be $72 million.

So what are Steel Excel shares/Steel Partners LP preferred units worth? I think it’s worthwhile to break down the cash flows into buckets and value each using a spread over treasury rates. I ran some numbers using current treasury rates and various credit spreads: 200 basis points over treasureies for 0-3 year cash flows, 350 basis points over for 3-6 year flows, and 500 basis points over for cash flows in years 6-9. The resulting calculation values Steel Excel shares at $17.09, 16% higher than the current trading price. At $17.09, Steel Excel shares would provide an IRR of 6.7%, which seems fair to me.

In reality, I don’t expect the gap between the current Steel Excel price and the face value of Steel Partners LP units to close because of the rich interest rate spread, I expect it to close because investors will see a listed preferred unit trading at a 17% discount to face value (at a $14.75 trading price for Steel Excel shares) and bid the price up.

The Steel Excel merger is expected to close in the first half of 2017 and is subject to a shareholder vote. Holders of more than half of the 36% of shares not owned by Steel Partners LP must approve the deal. GAMCO owns one third of those shares and has implicitly blessed the merger, so I don’t expect approval to be a problem.

Alluvial Capital Management, LLC manages a private investment partnership. If you are a qualified client and are interested in learning more, please contact us at info@alluvialcapital.com.

Alluvial Capital Management, LLC holds shares of Steel Excel Inc. for client accounts. Alluvial may buy or sell shares of Steel Excel Inc. at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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Falling Peso Benefits Rassini SAB de CV

Alluvial Fund, LP is now accepting limited partners. I can’t say much more about it here, but please contact me if you are interested.

The last few years have seen a stunning decline in the value of the Mexican Peso, from around 13 to the US Dollar in 2012 to over 20 today. The scope of this decline spurred me to take a look at an old favorite, Rassini SAB de CV, and I’m very glad I did.

A Mexican company, Rassini is North America’s largest producer of suspension components for light consumer and commercial vehicles, especially pickup trucks. The company is also a major producer of brake components, with two plants in Michigan. Rassini also has operations in Brazil. Notably, Rassini earns nearly all its revenues in US Dollars, but the large majority of its expenses are in Pesos.

My original thesis for investing in Rassini was expected debt reduction and margin expansion, driven by strong US auto sales and the weak Peso. The idea worked very well, and I sold when shares reached a reasonable valuation.

Since then, the company has continued to prosper. Revenues have risen substantially, both organically and debt has been further reduced. Margins have widened as revenues come back in ever more valuable US Dollars. Shares are somewhat higher than where I sold a few years back, but the company’s valuation has once again compressed to very attractive levels.

Simply put, the market has not adequately anticipated the dramatic increase in Rassini’s earnings power as a result of the recent plunge in the Peso’s value.

Here’s a look at Rassini’s most recent results, in Pesos.

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Every figure is a record. Now here are those figures in the context of Rassini’s valuation. The value of Dollar or Real-denominated debt is converted to Pesos, as closely as possible.

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Rassini appears very reasonably priced on trailing results. However, these results dramatically understate the company’s true trailing profitability, since the Peso was much stronger than it is now for most of the period. The next step is to see what Rassini’s results would have been at current exchange rates.

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At current exchange rates, Rassini’s revenues would have been much higher. Much of the difference would flow directly to EBITDA and EBIT, since Rassini’s cost base is substantially Peso-denominated. (The notable exception is the brakes division, which is US-based. More on that in a second.)

Simply adjusting Rassini’s trailing revenues to current exchange rates revalues revenues upward by nearly 2.3 billion Pesos. What about costs? Costs for the Mexican North American Suspension division would be virtually unchanged, given the salaries and plant expenses are in Pesos. Brakes, which is Michigan-based and pays expenses in dollars, would see a rise in translated expenses. But how much? Translated, the uplift in Brakes division revenue is 678 million Pesos. The 2015 annual report shows EBITDA margins for the brakes division of 19.2%. Assuming depreciation of 5% of sales (higher than the other segments) and an EBIT margin of 15% yields an EBITDA uplift of 130 million Pesos and an EBIT uplift of 102 million Pesos from the Brakes division.

The impact of the weak Peso on translated earnings from the Brazilian business can be ignored, since that business is operating at break-even right now.

The addition of 2.3 billion Pesos to Rassini’s EBITDA and EBIT (less the increased operating costs at Brakes) makes a huge difference in the company’s valuation.

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As the markedly different exchange rate environment translates into higher earnings in 2017, I expect the market to take notice and revalue Rassini’s shares.

Now, there are risks. The largest is the possibility of a slowdown in US auto sales, light trucks in particular. Sales of these vehicles have been strong for several years and may have plateaued. A sales decline would have a magnified negative impact on Rassini’s results due to operating leverage. I would not expect operating margins to decline to the previous low teens range, because of the beneficial currency impact. But they could decline to the high or mid teens range.

Another risk, and probably the one on everyone’s mind, is the possibility that free trade with Mexico will be substantially limited. Again, this could have a meaningfully negative impact on Rassini’s revenues and margins. But I think this risk is somewhat reduced by the fact that Rassini operates two plants in the US that provide many goods jobs. Rassini is less likely to be seen as a “parasitic foreign job-stealer” when it can point to the direct employment benefit it provides US blue collar workers.

Finally, there is the risk that the Peso will reverse its decline and Rassini’s profit bonanza will evaporate. Well, that’s the beauty of being a US investor in foreign companies operating in Dollars! If you convert dollars to Pesos and then use the Pesos to buy Rassini stock, you’ve created a natural hedge that will shield you from fluctuations in the USD/MXN exchange rate. You’ve essentially “locked in” the current exchange rate. For example, if the Peso continues to decline, the value of your Rassini shares will decline in Dollar terms. But, Rassini’s earnings will increase! So it’s a wash. The opposite occurs if the Peso strengthens. Your investment is immediately worth more, but Rassini’s future earnings will decline.

I believe investors purchasing shares at current levels are more than adequately compensated for these risks, and I expect great results from Rassini in 2017.

Alluvial Capital Management, LLC holds shares of Rassini SAB de CV for client accounts. Alluvial may buy or sell shares of Rassini SAB de CV at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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NYC Trip and Coats Group Plc – LSE:COA

Quick note: I’ll be in Midtown NYC from December 5-7. I’d be happy to meet up with anyone interested in knowing more about Alluvial’s soon-to-be-launched private partnership, or any blog reader. Get in touch.

w2xozx5vI believe shares of Coats Group Plc, traded in London, are attractive. Coats Group’s operating business is valuable and the holding company is significantly over-capitalized. Once the company settles its legacy pension issues, I believe the company will return capital to shareholders.

Coats Group Plc has a storied history. Founded in Scotland in 1755, it predates even the famed Scottish Widows Fund. Coats actually invented cotton thread as a wartime substitute for silken thread. Coats was floated on the London Stock Exchange in 1890 and underwent a series of mergers before being bought by Guinness Peat Group in 2003. Guinness Peat Group itself has an esteemed history, with roots stretching back hundreds of years to the famed Guinness family of Ireland. Guinness Peat once held dozens upon dozens of investments around the world (and actually succeeded in scuppering the proposed merger between the London Stock Exchange and Deutsche Boerse), but has spent years divesting these holdings. Following the final round of divestments, Guinness Peat Group renamed itself after its sole remaining operating business, Coats Group.

Today, Coats is one of the world’s largest manufacturers of sewing threads and fasteners. These range from ordinary crafting yarns to high-specification fiber-optic and heat-resistant threads. Coats is the world’s second-largest supplier of zippers behind YKK. It’s a global business, and its a pretty good one. For the twelve months ended June 30, Coats reported adjusted operating income of $154 million on revenues of $1.46 billion. (Coats reports in USD, though it trades in GBP.) Results for the six months ended June 30 showed excellent improvement in adjusted operating income, as Coats has taken steps to close down loss-making operations and invest in higher-margin, faster-growing segments.

Before we can get closer to determining a value for Coats, we must consider a very significant confounding factor: legacy pensions. Though Coats (remember, formerly Guinness Peat) owns only one business, it remains responsible for multiple pension plans. Turns out these plans are rather under-funded. This finding by the British government put a halt to Coats’ plans to return its holding company-level cash to shareholders. Here’s a graphic from Coats most recent report showing the deficits at each legacy pension.

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Coats Group’s three major legacy pension plans are Brunel, Staveley, and Coats UK. Brunel is 68% funded. Staveley is 91% funded, and Coats UK sits at 84%. You might be thinking “by American standards, these really aren’t bad.” However, the UK pensions regulator doesn’t see it that way. In 2015, Coats agreed to contribute £55 million to the Brunel plan over 10 years. In June, Coats agreed to contribute £74 million to the Staveley plan.

Investigations into the funding status of all three pensions continue. For now, Coats has agreed not to distribute any of its holding company cash to shareholders and to use its substantial cash balance to support the pensions. The company continues to negotiate a settlement with the regulators. In its last report, the company indicated it would proceed to court hearings if a settlement could not be reached. No update has been provided, but I believe it is very likely the parties will arrive at an agreement, court-arranged or otherwise, before the end of 2017.

I believe any settlement will provide Coats with substantial leeway to return capital to shareholders. Coats actually holds enough cash (in GBP) at the holding company level to eliminate its pension obligations in their entirety. But there is no reason to assume the regulator will force Coats to bring its pensions to 100% funded status immediately. That would be absolutely unprecedented. Rather, the regulatory body and Coats will almost definitely agree on a plan in which Coats contributes a lump sum to the plans and commits to annual contributions.

Back to the operating business. As I mentioned earlier, Coats is producing normalized operating income of $154 million. This figure should rise in 2017 as Coats exits its unprofitable UK crafts business and benefits from strategic investments in high-performance threads and a promising software business. Long-term, Coats should be able to grow its top-line revenues slightly faster than world GDP growth. People will always need clothing, and Coats high-specification specialty threads should see growing demand.

I would be perfectly comfortable buying Coats for 10-12x EBIT. Assuming Coats can produce $160 million in operating income in 2017, that values the operating business at $1,600-$1,920 million. The operating company has net debt of $337 million for net value of $1,263-$1,583 million. Now, Coats does not own 100% of all of its operating subsidaries. Specifically, the Bangladeshi and Vietnamese subsidiaries are very profitable but not 100% owned. For the twelve trailing months, income attributable to minority interests was $12 million. When considering Coats Group’s valuation, these minority interests must be capitalized. I think a 12x multiple of income is reasonable for minority interests in emerging markets ventures.

At the holding company level, Coats has $396 million in cash versus combined pension deficits of $349 million. (In reality, this cash is held in Pounds. But the pensions are also GBP-denominated, so the net effect of currency movements is limited.) Just to be extra pessimistic, let’s say the regulators and Coats come to agreement to bring pension funding to 95%. Again, that would be unpredecented. But let’s go with it, because there is the possibility that the pension liabilities are under-stated. Anyway, 95% funding would require Coats to commit another $241 million of its holding company funds to the pensions. That would leave $155 million in funds available for distribution to shareholders, or for investment in the operating business.

Let’s compare Coats Group’s present valuation against the value of the operating subsidiary and the example excess holding company cash. Coats has a market capitalization of £528 million, or $668 million at current exchange rates. To that we must add the capitalized minority interest, which I’d put at $144 million. Total market capitalization: $812 million. There’s $337 million in operating company net debt, plus my very rough and conservative estimate of $155 million in excess holding company cash. That’s ultimate net debt of $182 million for an enterprise value of $994 million.

For your $994 million, you get $160 million or so in operating income for a multiple of 6.2x EBIT. That strikes me as extremely cheap for a reasonably good business producing high levels of free cash flow, albeit with only moderate growth potential. If my estimate of the value of the operating business is anywhere close to accurate, then shares of Coats should be worth nearly twice the current trading price. I think my valuation is supported by Coats Group’s free cash flow yield, which exceeds 10%.

Why so cheap? I think it all comes down to uncertainty. The market is fearful that the UK pensions regulator could proclaim the pension deficit is larger than anticipated or could call for onerous contributions. Brexit still weight heavily, then there is the fact that Coats Group is a small company despite its once mightly stature. Still, I think the current price represents a good value for investors willing to look past the next few quarters.

Alluvial Capital Management, LLC does not hold shares of Coats Group Plc for client accounts. Alluvial may buy or sell Coat Group Plc shares at any time. 

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial, please see alluvialcapital.com.

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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Transactions Costs, Amortization Disguising Earnings Power at Alerus Financial – ALRS

Note: Last chance to sign up for The MicroCap Conference in Philadelphia on October 24 and 25. It’s a great place to network and hear from some interesting small companies. Sign up here. If you’re going, please let me know. I’d like to meet you.

 

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Alerus Financial is one of my favorite little financial services firms. Despite being a bank, the majority of Alerus’ value actually derives from its non-banking segments like retirement plan administration, wealth management and mortgage origination. Alerus is one of the nation’s fastest-growing retirement plan administrators.

When I originally wrote about the company in 2013, Alerus was suffering from mis-classification. Investors were focused on the banking operations and assigned the business a conservative multiple, when the company’s fast-growing non-bank segments were producing the majority of revenues and earnings. Three years later, this remains the case. Since my original post, retirement plan and wealth management revenues are up 57% while net interest income from traditional banking is up 22%. (Revenues at the  company’s other significant segment, mortgage origination, are down. This is to be expected from a cyclical, interest rate-driven business like mortgage origination.)

The market did eventually catch on and Alerus’ shares rallied nearly 90% in the 2 years following my write-up. However, shares now trade more than 20% off the highs reached one year ago. What gives? In short, Alerus’ value proposition is once again obscured. Earnings per share have declined as a result of significant one-time expenses related to acquisitions, high on-going expenses related to amortization of intangibles, elevated personnel expenses due to hiring for growth, and declining contribution from the mortgage unit. Reported EPS has declined to $0.92 per share for the twelve trailing months, after peaking at $1.46 per share in 2013. Not too many companies are going to see stock appreciation in the face of a 37% decrease in reported earnings.

Alerus appears to trade at around 17x trailing earnings, probably a defensible valuation for this sort of banking/non-bank financial services hybrid business. However, normalized earnings power is substantially greater on a forward basis because of one-time costs in the trailing earnings figure and future earnings contributions from some recent acquisitions, such as:

  • The addition of $350 million in banking assets via the acquisition of Beacon Bank in Minnesota. The acquisition, which saw Alerus expand into the Duluth market, closed in January. A full year’s earnings contribution from Beacon Bank is not yet reflected in Alerus’ results, but one-time costs associated with the acquisition are. Additionally, the acquisition created an amortizable deposit premium asset which has reduced Alerus’ earnings, but not its cash flows.
  • The acquisition of Alliance Benefit Group North Central States, a retirement plan administration overseeing accounts for over 75,000 participants and $6 billion in plan assets. The purchase also closed in January, creating one-time expenses and an amortizable asset.

For the second quarter of 2016, Alerus reported net income of $2.94 million and EPS of $0.21. Let’s take a crack at normalizing this figure. In the quarter, Alerus recorded $2.1 million in one-time costs related to conversion and integration expenses for the newly-acquired Beacon and Alliance assets. Alerus also recorded $414,000 in one-time expenses related to extinguishing FHLB borrowings.

Most interestingly, Alerus recorded $1.78 million in intangible amortization expense for the quarter. This expense is intended to represent the declining value of acquired bank deposits from Beacon Bank and customer lists at Alliance Benefit Group North Central States. This expense has no cash impact on Alerus beyond reducing its taxable income, yet intangible amortization has become a very meaningful income statement item for Alerus as it continues to be an enthusiastic acquirer. The increasing levels of amortization have had a seriously negative impact on reported earnings without impacting cash flow.

Here is a look at Q2 earnings with the one-time expenses and non-cash charges stripped out. Alerus’ tax expense has hovered around 36% of pre-tax income for some time, so I am using that to estimate the tax shield from one-time expenses.

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After adjusting for the acquisition-related and debt extinguishment expenses, Alerus’ net income look substantially better at $4.5 million, 55% higher than the reported figure. Things get even better when we adjust for the substantial non-cash amortization expense. Alerus’ adjusted cash EPS is more than twice the reported figure at $0.45 for the second quarter.

I wish computing Alerus’ P/E ratio were as easy as annualizing this adjusted Q2 figure, but it is not so. While the company’s banking, retirement plan administration and wealth management segments show minimal seasonality, the mortgage origination unit performs substantially better in the second and third quarters. We can compensate for this factor by adjusting Alerus’ Q2 mortgage income down to the average figure for the twelve trailing months, which happens to be $6.26 million. We’ll also have to make an assumption on the segment’s operating margin. I think 20% is appropriate, given that Alerus as a whole has an efficiency ratio of around 80%.

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Call the $0.43 adjusted adjusted quarterly cash EPS. (I am aware we’re getting deep into adjusted territory and the dangers of such. Still, I don’t believe I have committed any unjustifiable logical leaps.)

Annualizing that figure yields estimated forward cash EPS of $1.74 without assuming any growth. Looks like Alerus’ earning power has continued to increase, only now it is being disguised by the rising non-cash amortization expenses and transactions costs.

On today’s price of $16.60 or so, Alerus is trading at a normalized forward P/E of 9.5. In my opinion, this is far too cheap a price for a company with a history of strong growth in its non-bank operations, and stability and profitability in its banking segment. It is possible that income from mortgage operations will decline further in the face of rising interest rates, but I believe the current valuation more than compensates investors for this possibility.

Alluvial Capital Management, LLC is launching a private investment partnership. If you are an accredited investor and are interested in learning more, please contact us at info@alluvialcapital.com.

Alluvial Capital Management, LLC holds shares of Alerus Financial for client accounts. Alluvial may buy or sell shares of Alerus Financial at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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Flughafen Wien AG

Shares of Flughafen Wien AG offer the chance to invest in critical world-class infrastructure at a singularly low valuation. Flughafen Wien is insulated from competition, only modestly leveraged, and its services are critical to the modern economy.

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Long-time readers may know I have an affinity for businesses that are insulated from competition and enjoy at least a degree of pricing power. Past examples include Jungfraubahn AG (nobody’s constructing major new tourist railways in the environmentally-sensitive Swiss Alps) and Logistec Inc. (Cargo needs to be loaded and unloaded at a specific port. There are few alternatives.) Shares in companies like these exhibit highly desirable “equity bond” characteristics where long-term shareholder returns will approximate the current earnings yield plus organic unit demand growth plus inflation. The best of these companies rarely experience declining or stagnant earnings due to the critical nature of their operations and their strong competitive positions.

Because of the stability and strong long-term outlooks that these businesses typically enjoy, they often trade at bond-like earnings yields. Not so for Flughafen Wien. While competitors offer free cash flow yields as low as 3%, Flughafen Wien offers a free cash flow yield of nearly 8%, despite a strong outlook.

So what does Flughafen Wien actually do? Simple. The company owns and operates the Vienna International Airport along the Danube River to the south-east of Vienna, Austria. Additionally, the company owns a 48% interest in Malta International Airport and a 66% interest in Slovakia’s Košice Airport. The Vienna Airport is, of course, the company’s major asset. The airport was originally built in 1938 as a military facility, then taken over by the British following World War II. The Austrian government expanded and improved the airport over the following five decades, and privatized it in 1992. Today, just 11.8% of the company’s shares are freely floating. 50% are owned by local governments and an employee ownership plan, and 38.2% are owned by a major Australian infrastructure investment group, IFM Global Infrastructure Fund. IFM has expanded its ownership aggressively in recent years, but more on that later.

About 55% of the company’s revenues are its airport operations: collecting income from passengers and airlines who use the airport facilities. The next biggest segment is “Handling” at 23% of revenues. Handling refers to a variety of activities including prepping aircraft between flights, loading and unloading cargo, security services, and other services that ease the movement of passengers and aircraft. A further 20% of revenues consists of retail and property revenues associated with parking, rents on commercial storefronts and restaurant spaces within the airport, advertising space, and more. While it is the smallest of the three major revenue segments, Retail and Properties actually accounts for 48% of the company’s operating income. Airport operations are the second most profitable segment, making up 37% of EBIT, while Handling contributes less than 10%. The graphic below from the 2015 annual report illustrates this more clearly.

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Recent years have been good for the Vienna Airport with steady passenger growth and rapid improvement in financial results. This is despite weak economies and instability in destinations to Vienna’s east, especially in Russia and Ukraine. From 2010 to 2015, annual passenger movement at Vienna International Airport rose at an annual rate of 3.0%. Strong operating leverage (a high percentage of fixed costs vs. variable costs) allowed operating income to rise by 6.9% annually over the same period. Meanwhile, net debt has been cut in half.

Things were not always so rosy at Flughafen Wien. As recently as 2011, the firm was troubled by massive cost over-runs in the construction of its Skylink addition to Terminal 2. But a new management team and a scaled-back capex program righted the ship and the company is now on solid operational and financial footing. At Eur 22 per share, Flughafen Wien trades at less than 8x EBITDA and a P/E of 17.2, with a free cash flow yield of 7.8%. This represents a very large discount to the valuations of other major European airports and airport groups.

The graphic below displays financial statistics for other publicly-traded European airport operators. Figures are in millions USD using today’s exchange rates.

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You will see that Flughafen Wien’s valuation compares very favorably to its peer group, despite above average revenue growth and below average leverage. The only area where the company comes up short is its operating margin, which is slightly below its peers. The Copenhagen is the clear superior operator of the group, with excellent revenue growth and margins. But that is fully reflected in its premium valuation. The only other operator with similar figures to Flughafen Wien is Fraport AG. However, Fraport (which operates the Frankfurt airport) suffers from sub-par operating margins and carries a large amount of debt.

So why does Flughafen Wien trade at a material discount to its peer group? The biggest reason is likely the market’s nervousness about the company’s major destinations outside of Western Europe. Departures to Central and Eastern Europe were down 5.3% in 2015 and down 14% from the peak in 2012. Moscow in particular has experienced a serious decline. The market likely fears further declines in departures, which is entirely possible given the threat of Russian aggression and continued sluggish economic conditions.

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Then there is the prospect of major capital projects on the horizon. Flughafen has elected to go forward with a project to modernize and expand its facilities, to the tune of Eur 500 million between now and 2023. The company says the project will enhance its profits, especially via the creation of additional shopping and restaurant space, but investors may be justifiably nervous about potential cost over-runs and delays. Investors may have short memories, but their memories are not short enough to forget that a botched expansion nearly brought down the company only five years ago. I believe this risk is mitigated by the new management team and Flughafen Wien’s very reasonable leverage, but the risk remains.

Finally, there is the fact that Flughafen Wien is one of the smallest public European airport operators, with few shares in public hands. The 11.8% of the company held by the public is worth only Eur 218 million at current prices, ruling out investment in the company for most infrastructure funds and other investment companies of size.

And that’s where the opportunity lays. Readers should know I have absolutely no qualms about investing in controlled companies, so long as the controlling shareholders are motivated to increase shareholder returns. This is certainly the case with Flughafen Wien with IFM owning nearly 40% of shares. There is also a meaningful possibility that IFM will take steps to further increase its ownership. IFM’s first tender offer came in November 2014. IFM paid 20.50 Euros (split-adjusted) per share and netted 29.9% of the company. The second tender offer made in April 2016 collected another 8.3% of shares. This time, IFM paid Eur 25.00 (again, split-adjusted) per share. What price might IFM offer in a third round? Whatever that price may be, another holder of Flughafen Wien stock thinks previous offers have been far too low. The UK’s Petrus Advisers put out a presentation supporting its view that Flughafen Wien shares are worth as much as Eur 36.50 per share, after accounting for the 4-for-1 share split that Flughafen Wien recently did.

It honestly concerns me little whether IFM tenders for the rest of the publicly-held shares or not. I am happy to hold a top-quality infrastructure asset at a low-grade valuation for as long as the market allows me.

Alluvial Capital Management, LLC is launching a private investment partnership. If you are an accredited investor and are interested in learning more, please contact us at info@alluvialcapital.com.

Alluvial Capital Management, LLC holds shares of Flughafen Wien AG. for client accounts. Alluvial may buy or sell shares of Flughafen Wien AG at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. 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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Brief Update – Announcing Alluvial Fund, LP

I am pleased to announce that my investment management company, Alluvial Capital Management, LLC, will be launching a private investment partnership. Sitestar Corporation will be providing $10 million in seed capital for Alluvial Fund, LP. You can read their press release here.

Details are very preliminary, but we are targeting a January 1, 2017 launch date. If you are an accredited investor and are interested in knowing more, please send me an e-mail at info@alluvialcapital.com and I will provide additional information as it becomes available.

In other news, I’ll be in Philadelphia on October 24th and 25th for The MicroCap Conference. Previous conferences have been great opportunities to hear from some promising small companies and to network with other investors. I hope to meet some readers there.

 

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