Pope Resources Offers Cheap Inflation Protection: POPE

Something I’ve been trying to do for Alluvial’s “Global Quality and Income” strategy is to build in a little additional inflation protection. Equities offer a decent inflation hedge in and of themselves, but I believe certain industries offer especially good protection, typically industries that own hard assets. One specific industry with attractive inflation hedging qualities is timber. In the course of seeking out a suitable investment candidate, I’ve come across what I believe to be an extremely well-managed but over-looked timber company: Pope Resources, LP. Pope Resources boasts a long history of success, an astute management team and a strong collection of forestry and development assets.

There’s something delightfully simple about the timber industry. Plant a forest. Tend to it as it grows. At the proper time, harvest the timber and re-start the process. I don’t mean to imply that forestry is easy or doesn’t require a lot of skill. On the contrary, I’ve seen what goes into a well-managed forestry practice, and it requires an incredible level of scientific and market knowledge. And the labor involved at the ground level can be backbreaking and dangerous. But compared to the complicated financial engineering, frantic advertising and ruthlessly short product lifecycles that characterize many industries and companies, forestry seems a calm, timeless enterprise that has occupied mankind for thousands of years and will continue to do so.

Pope Resources was spun out as an MLP from Pope & Talbot in 1985. Over the years, the company has stewarded its forests, harvesting according to market conditions and also selling off various parcels to real estate developers. Today, Pope Resources owns 110,000 acres of timberland in Washington and Oregon, plus another 2,900 acres of property held for development in Washington. Additionally, Pope Resources has a private equity business that manages timberland funds holding 91,000 acres. Pope’s own interest in these funds is approximately 15%.

I’m no timber expert. I did grow up in a timber-producing region and spent a miserable summer toiling in a sawmill, but my knowledge of the financial and investment aspects of the industry come solely through my readings on the subject. I don’t know if the acreage held by Pope Resources is more or less productive than other parcels in the Pacific Northwest, nor if the company’s specific species mix and tree age profile will result in higher or lower yields in coming years. However, I believe I can trust management to get the most from its assets. I may not be a timber expert, but I believe I can recognize a well-managed company when I see one.

Short-term stock returns are driven by all sorts of factors, some within management’s control and others, not. But long-term returns to shareholders are strongly influenced by the quality and composition of a company’s assets, and the competency with which those assets are managed.  A look at Pope Resources’ historical returns to unitholders indicates just how potent the combination of good assets and good management has been. Short-term performance has been competitive, while long-term performance has been superior.


I did my best to construct a set of comparable companies, against which to compare Pope Resources. Some of these companies also have operations in pulp, newsprint and other timber-adjacent businesses, but for the most part they make their money the same way as Pope Resources. Besides Rayonier, which benefited from its performance fibers business for most of the time periods in question, Pope Resources is the clear champion, multiplying unitholder wealth more than sevenfold over the past two decades. Of course, past success is no guarantee of future excess returns. But I have found that competent management teams typically continue to behave competently, while inept management teams usually continue to…..well, just take a look at Louisiana-Pacific. I trust Pope Resources’ leaders to continue to steward the company well. Management’s own holdings in the company are currently worth nearly $40 million, easily enough to incentivize them to continue to growth the company’s worth. It’s not just me who thinks highly of Pope’s management. Rayonier recently split into two companies, with the CEO headed to the spin-off fibers company. Who did Rayonier tap to take over leadership at the legacy company? None other than the CEO of Pope Resources, David L. Nunes. Pope has since replaced Mr. Nunes with Mr. Thomas M. Ringo, previously the CFO. With 25 years at Pope, Mr. Ringo is a fine choice to take the reins.

Pope’s management has put out a series of helpful presentations to investors which highlight the company’s strengths. Among them are:

1. An attractive asset mix – Pope’s standing timber has a high concentration of Douglas Fir, which commands a pricing premium.

2. Strong export capabilities – Pope’s location allows it to meet surging demand from Asia for premium wood products. The export market accounted for 40% of revenues in 2013.

3. Excellent development opportunities – Pope’s development properties are situated just outside the Seattle. The Seattle metro is one of the best-performing markets in terms of job creation and unemployment in the US, a fact that should help Pope profit on sales of land to developers. Thus far in 2014, Pope has reaped $15 million from land sales, more than twice the book value of the land sold, and expects to “harvest” large rewards from land sales in the Seattle area from the present through 2015. At quarter’s end, Pope’s land held for development had a book value of $27.6 million.

Pope Resources may possess a strong mix of assets and a savvy and an incentivized management team, but I still wouldn’t be so interested if the company’s trading price exceeded the value of its assets. Fortunately, that’s not the case. On a per-acre basis, the market values Pope at a discount to comparable timber properties in the Pacific Northwest.

Because GAAP rules force the company to consolidate its managed funds, Pope’s GAAP balance sheet is a little misleading. Fortunately, since the company provides detailed information on the timber acreage and associated debt of each fund, it is possible to determine the company’s proportional acreage and to compare this against adjusted enterprise value. First, the acreage.


Pope’s net acreage of 123,650 excludes the 2,900 in development land, but I’ll account for the that in the enterprise value. Net comes the task of calculating enterprise value.


The final step in calculating Pope’s value per acre of timber is to adjust enterprise value for the company’s development land. This is more of an art than a science, since the selling price of the Washington land can’t be predicted with any degree of accuracy. Recent land sales have occurred at more than twice book value, so I’ll consider three scenarios: one where the land is worth book value, one where it’s worth 1.5x book value and one where it’s worth 2x book value.


Book value multiples of 1.0-2.0 imply per acre valuations of $2,112 to $2,335. Either end of this range is below the average valuation of comparable properties in Pope’s location and market segment. The most recent data from NCREIF pegs valuations for Northwestern US timberlands at right around $2,400 per acre. Pope’s strong asset profile likely justifies an above-average valuation, but I’m fine using NCREIF’s estimate as a measuring stick. NCREIF notes that timber valuations are experiencing support from Asian demand, but housing starts in the US remain well below their pre-crisis levels, tempering prices. Should housing starts pick up steam, timber prices may rise. Or, they may fall. I don’t waste my time trying to predict moves in commodities prices. As uncertain as the market can be in the short run, I am confident of one thing: Pope Resources will continue to reward unitholders for many years to come.

Pope Resources, LP is a master limited partnership. MLPs carry unique tax considerations, especially for tax-deferred accounts. Investors should carefully examine these tax effects before investing in MLPs. 

Alluvial Capital Managment, LLC holds shares of Pope Resources, LP  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.




North State Telecommunications Corporation – NORSA/B


North State Telecommunications is a North Carolina telecom provider that has transformed itself from a sleepy traditional telco into a growing provider of high margin services like data centers and broadband access. Despite  the company’s success, the market still values North State like the stagnant company it once was, with a double-digit free cash flow yield and an 8% dividend yield.

North State Telecom’s root stretch all the way back to 1895, when it was established as a local telephone exchange serving the High Point, North Carolina area. The company grew and grew, purchasing nearby telephone systems and expanding into wireless and internet services. North State has long been run for cash, paying out most of its free flow in dividends. In recent years, this approach has tried the patience of a set of activist investors, who have attempted to compel the company to uplist to a major exchange, leverage up, or sell itself outright. Thus far, North State shareholders have voted down the efforts of the minority group to force change. Still, North State has made moves to free up capital and invest  in high-growth business lines. In 2012, it agreed to sell its operated wireless operations to AT&T for $23.5 million dollars. In 2013, North State opened a data center in Raleigh and began construction on another in Charlotte. Most recently, North State announced it would provide gigabit internet to certain service areas by the end of 2014.

North State’s labels its data centers, consumer broadband and business wireline business its “strategic” segments, which have superior profit margins and better growth potential than its legacy consumer wireline and wholesale businesses. For the first quarter, strategic revenues rose 4.3% year-over-year while legacy revenues declined 2.5% for net revenue growth of a positive 1.8%. Residential broadband and data center revenues were the standouts, helping to push strategic revenue to over 65% of the total for the first time.



North State’s investment in data and broadband has resulted not only in top-line growth, but also in restored profit margins. North State’s margins and results had been flagging as consumers let go of their wireline service, but the new revenue streams have pushed the company’s EBITDA margin comfortably over 30% once again, and its EBIT margin back over 10%.  Below are North State’s results for 2012 and 2013, and the twelve trailing months through the end of Q1 2014, in millions.


Readers should note that North State earns a substantial portion of its income from ownership interests in non-consolidated affiliates. The primary asset in this category is a 5.81% stake in Alltel of North Carolina LP, a wireless company operated by Verizon. North State’s interest in the Alltel LP and a much smaller interest in a municipal telecom provider earned them $7.4 million for the twelve trailing months.

While North State’s operations have gained momentum, the company has used its strong cash flow and asset divestment to reduce debt and build cash. Combined with a much smaller pension liability, North State is a much less leveraged company than it was in 2012.


Net leverage is now a very comfortable 1.0x EBITDA + equity income. North State’s pension liability has been cut dramatically via strong stock markets gains, and also by closing the pension to new participants and making other benefit reductions. The pension is invested approximately 50/50 between equities and fixed income, and carried an 8.0% return expectation as of 2012. Should equity market turn south, the pension deficit will widen, but it’s not likely to be at an issue with cash and securities holding so much higher and debt lower than in 2008.

North State has two share classes: A and B. Both are very illiquid, but the A shares are much, much more so. B shares are fewew in number and non-voting, and currently trade at a bid/ask spread of $63.75/$65.00 while the A shares trade at $68.75/$80.00. In looking at North State’s valuation, I’ll use B shares figures, since they’re much cheaper. At these prices it’s rather pointless to purchase the A shares, unless one wants to mount an activist campaign.


North State’s valuation points to market expectations of flat revenues, earnings and cash flows, but I suspect the market is wrong. After all, EBITDA + Equity Income rose a very healthy 6.5% in Q1 2014 versus Q1 2013, better by leaps and bounds that what a typical traditional telco could produce in the current technological and economic environment. If Q1 figures are a good indication of what North State can do for the entire year, EBITDA + Equity Income will rise 7.4% over 2013′s figures. This figure does not include the additional revenues that North State will earn from its Charlotte data center once that is opened, or from its gigabit internet initiative if that proves popular. If North State truly is the internet and data company it says it is, it’s worth much more than the modest ratios its stock now commands.

Alluvial Capital Management, LLC does not hold shares of North  State Telecommunications Corporation for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.

Blog and Business Updates

Today’s post is a brief departure from my usual discussion of micro-caps and illiquid stocks, and instead contains some updates and news on the blog and on my RIA firm. Regular posting will resume later this week with a profile of a true rarity in today’s market: a profitable net-net, this one in Australia.

The Business

It’s been nearly six months since I started my RIA firm, and I’ve never had so much fun at work! It’s been a great pleasure to manage portfolios for many readers. Being a one-man shop is a lot of work, but finally being able to buy promising securities for clients rather than merely writing about them online is such a great feeling. Assets under management is growing quickly, but there’s still plenty of room for new clients! Drop me a line if you’re interested.

That brings me to an important announcement: the name of my RIA firm is changing from Catalpa Capital Management, LLC to Alluvial Capital Management, LLC. Nothing else about the business is changing except for the name. The change should show up on FINRA soon, and the new website is alluvialcapital.com.

The Blog

Long-time readers may have noticed a decline in the frequency of new posts on OTC Adventures. The main reason for the decline is my RIA duties. Writing new blog posts necessarily falls lower on the list of priorities than performing research and managing client accounts. Besides that, it’s simply more difficult to locate clearly cheap stocks. It’s not impossible, in fact I think anyone who claims all the good values have been eliminated by the rising market is just not searching very hard. However, the days when I could browse through filings for an hour and come up with a list of a dozen dirt cheap American OTC stocks are over for now. That’s the reason that more than half of the new posts I do are on exchange-traded companies outside the US. Many international markets still abound with tiny, cheap companies waiting to be discovered by investors. Here are a few of the areas where I am finding a good number of promising stocks:

  • Western Europe, particularly France, Germany and Switzerland – These nations abound with family-controlled micro-caps and larger companies with low floats due to the presence of controlling shareholders. So long as the owning families or controlling shareholders have a history of stewarding their companies well and treating outside shareholders fairly, I’m happy to buy in at valuations and ratios that are a distant memory in US markets. So far, I’ve found bargains in real estate and manufacturing, though nearly every sector offers value.
  • Australia – The perception of Australia that many investors have is of an economy dominated by raw materials and energy and beholden to China’s appetite for coal and iron ore. There’s a grain of truth to that, but it obscures the hundreds of small Australian companies that have nothing to do with the resource economy. For example, I’ve found bargains in agriculture, consumer goods and logistics, and I’ve only just begun my search. Another nice feature of Australian companies is the dividend culture that exists there. Australian companies normally pay out high portions of their earnings in dividends, which I find tends to discourage management from frittering away earnings on dubious investments.
  • Mexico – Mexico suffers from a reputation for shaky creditworthiness, high inflation and social issues. Investors who focus on these perceptions may miss that fact that Mexico’s per capita GDP rose 27% from 2009 to 2012, and will likely keep growing following the liberalization of the nation’s energy sector. I’ve found bargains in consumer staples and auto suppliers.
  • “Exotic” Exchanges - Lately, I’ve been spending time seeking out local exchanges in developed nations that for whatever reason aren’t widely available to Western investors. I’ve not yet found ways of accessing many of these exchanges, but several offer incredible value, if the stocks can be bought. In the interest of keeping it that way, I won’t be talking about them here…..

Thank you, as always, for reading OTC Adventures. I’ve benefited immeasurably as a writer, analyst and investor from your comments and e-mails. Nearly without fail, each time I write up a company I get several e-mails from company or industry experts offering insights and perspectives that I would struggle to arrive at myself. Please feel free to contact me at any time.

Teak Holz International AG – Vienna Exchange: TEAK


Now and then I run across a company with a truly unusual business model. So far as I know, Teak Holz International AG is the only pure-play publicly-traded producer of teak wood in the world. (If I’m mistaken, I welcome corrections.) Teak Holz is established in Austria and traded in Austria and Germany, but owns nearly 4,800 acres of teak producing land in Costa Rica. Teak is a tropical wood that has long been prized for use in furniture, boatbuilding and construction due to its excellent durability and water resistance. The tree is native to Asia, but is now cultivated in Central and South America as well. The teak industry increasingly uses sustainable forestry methods and complies with fair labor practices, and Teak Holz emphasizes its leadership in these areas. The company’s teak plantings are not yet mature, and many years will pass before Teak Holz realizes meaningful cash flows from harvesting timber. Teak Holz’s unusual cash flow profile complicates the valuation, which makes the company all the more interesting to me. Even more interesting is the company’s 79% discount to tangible book value.

Most of the companies I evaluate and invest in are dependable cash generators. Valuing these companies is a process of normalizing this cash flow and applying the appropriate multiple based on industry prospects, capital structure and management quality, among other factors. Businesses like Teak Holz present a different challenge because their cash flows are far off and highly uncertain. The present value of the future cash flows generated by Teak Holz’s timber harvest is highly sensitive to factors like discount rates, harvest timing and teak prices, all of which are impossible to predict with any degree of accuracy.

According to the company, the growth period for Central American teak crops is 15 to 20 years. The majority of Teak Holz’s trees are 5 to 6 years old. Not saplings, but also not ready for harvest. Between now and then, these plantings will be thinned multiple times, allowing the remaining trees to increase in diameter and become much more valuable. These thinnings will generate a small amount of positive cash flow, but the big payday will not arrive for another 10 to 15 years. Teak Holz provides an estimate of the present value of its teak crop. Discounted at 12.75%, Teak Holz’s own estimate of its cost of capital, the company values its teak assets at €97.65 million at the end of fiscal 2013. This figure is net of all costs to plant, manage and harvest the teak crop.

As of fiscal 2013, Teak Holz’s balance sheet looked like this, in millions of Euros.


Teak Holz has EUR 77.24 million in balance sheet equity value, yet its market capitalization is only EUR 14.97 million. That’s among the largest discount to book value I’ve seen, especially for a company not in dire financial straights. Teak’s 79% discount to tangible value is just as stark.

That leaves us with a question: why? Why does the market assign such a massive discount to the stated value of Teak Holz’s assets? Turns out, there may be some solid reasons.

Possibility #1Overstated Assets

Perhaps Teak Holz is simply wildly over-estimating the value of its teak plantations. It’s a reasonable hypothesis because Teak Holz recently took a huge writedown, reducing the estimated value of its teak assets from over EUR 135 million to the current figure of nearly EUR 98 million, a reduction of 28%. Ouch. The writedown was done in response to a new valuation survey commissioned by the company after a significant leadership change. For the first time, the company contracted an outside expert, Legacy Appraisal Services of Gainesville, Florida, to provide a new estimate of the teak crop’s value. Legacy Appraisal Services’ valuation process incorporated much less optimistic inputs for teak prices and harvest yield than the company’s own process, resulting in a substantially decreased balance sheet value. The new balance sheet value is likely closer to the actual present value of the company’s teak harvest, but investors may remain suspicious of the company’s published figures. Nobody wants to invest in Teak Holz, only to suffer through another 10% of 20% writedown.

Possibility #2 – Financing Issues and Dilution

While Teak Holz may ultimately realize a handsome profit on its teak harvest, the company will have to fund its ongoing corporate expenses in the interim. These expenses reduce the value that shareholders will ultimately realize from the teak crop, moreso because they are current expenses while the teak harvest cash flows will not be received for several years. In fiscal 2013, Teak Holz spent roughly EUR 3.2 million on operating expenses, compared to EUR 2.6 million in fiscal 2012. Because Teak Holz has minimal cash reserves and nearly no revenues, these operating expenses must be funded by raising capital or selling assets. This is where the company’s depressed stock price becomes a serious issue for the company and for shareholders. Selling equity as a means of funding operations is extremely unattractive, because selling shares at 19% of book value is extraordinarily dilutive. Traditional debt financing is only marginally feasible because the company has little capacity to make periodic interest payments. Payment-in-kind debt would circumvent this issue, but such debt usually comes at a cost of high, high rates. In order to finance its ongoing operations, the company has settled on a mix of bank debt, loans from a related party and convertible debt. Teak Holz’s bank debt of EUR 4.96 million is secured by a mortgage on the personal property of a company insider, who in turn holds a contingent mortgage claim on one of Teak Holz’s plantations. The same insider has also provided Teak Holz with a EUR 3 million loan, again secured by one of the company’s plantations. Finally, the company has EUR 11 million par convertible bonds outstanding, bearing interest at 5%. These bonds come due in 2015 and are convertible at a share price of EUR 5. Since the last annual report was filed, Teak Holz sold an additional EUR 2.35 million in convertible bonds with the same terms. Refinancing the convertible bonds is a looming issue for the company, one that sustains uncertainty and contributes to the depressed valuation.

Simply put, Teak Holz’s small size, ongoing cash needs and depressed valuation leave the company with few good financing options. The market may rightly be pricing in the possibility of significant dilution between now and the eventual teak harvest, an outcome that would reduce investors’ pro rata shares of the eventual harvest proceeds.

Possibility #3 – The Market is Wrong

Questions concerning asset value and financing risks notwithstanding, it’s possible that the market simply has Teak Holz all wrong. Perhaps the teak assets are fairly valued or even under-valued, and perhaps the company manages to fund its operating expenses at a reasonable cost between now and the first big harvest in several years. In that case, investors buying at this price will likely do very well.

Unfortunately, I can’t get comfortable enough with Teak Holz’s financial position to even consider possibility #3. Rather than rely on expensive and short-term convertible debt financing, I’d rather see the company execute some long-term forward timber sales or selectively sell acreage/plantation ownership interests. (A little strategic self-liquidation doesn’t hurt anyone. If Teak Holz’s acreage is really worth what they say it is, they shouldn’t have too much trouble liquidating a little each year at a price sufficient to fund operations.) The company has announced some medium-term forward timber sales, but I’d be happy to see them explore this financing method further. Another factor that gives me pause is Teak Holz’s management team. The corporate officer and director ranks seem to be a revolving door of Austrian businessman who know each other through outside business dealings. I am not suggesting any nefarious activities are in progress, but I’d rather see some consistency in leadership and a few more experts in teak and Costa Rican forestry.

That said, Teak Holz is a fun one to watch and a nice change from the typical industrials, banks and telecoms that are my bread and butter. As a final note, Teak Holz’s convertible bonds may make an interesting speculation. They trade on the Vienna Exchange with the ISIN AT0000A0K1F9. The last trade was at 76.101 for a yield to maturity of 29.1%. More importantly, they have plenty of asset coverage if Teak Holz’s harvest valuation is even remotely realistic. Please note I am not any kind of authority on Austrian fixed income and bankruptcy law, so I have no idea what special risks these bonds would carry.

Alluvial Capital Managment, LLC does not hold shares of Teak Holz International AG  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.

Sanluis Corp. SAB de CV: Fast-Growing, Deleveraging Auto Supplier at a Cheap Price

Today’s investing idea takes us to Mexico, where a small company has quietly become the world’s leading producer of light vehicle leaf springs, and the top provider of suspension components for light trucks in the Western hemisphere. Sanluis Rassini made its first sale to Ford’s Mexican operations in 1938 and began exporting to the USA in 1970. Sanluis spent the 80s and 90s adding plants and offices in Mexico and the United States, and expanding into Brazil. From 1988 to 2013, Sanluis grew its revenues at an astounding 19% annually. However, for most of that period, Sanluis was hampered by a crushing debt load. This debt load lead to a default and restructuring in 2010. Sanluis emerged from the restructuring with a strengthened balance sheet and has continued to reduce its net debt, both in absolute terms and relative to EBITDA and cash flows. Results at Sanluis have climbed to record highs, powered by the strong sales of light trucks like the Ford F-150 and the Chevrolet Silverado. Sales growth for light trucks has outpaced the recovery in small automobiles, and the trend seems likely to continue as the US labor market improves. Results at Sanluis’ Brazilian subsidiary have lagged, but could provide an additional tailwind when and if the Brazilian economy recovers. Despite its reduced leverage and bright business outlook, Sanluis trades at very low multiples of EBITDA and EBIT, and offers a double digit free cash flow yield.

Results and Outlook

Since the lows of 2009, Sanluis’ revenues have nearly doubled, topping $900 million USD for the twelve trailing month period. Forward revenues should be considerably higher. According to data provided by the Wall Street Journal, US pickup truck sales volume rose 3.6% year-to-date through May versus 2013, strongly outpacing cars. Sanluis’ components can be found in eight of the top ten selling pickup trucks in the US, so the sales increases are benefiting Sanluis’ results. To wit, revenues for the first quarter of 2014 were up 20% year over year. The chart below summarizes Sanluis’ results from 2009 to present. Amounts are in millions and are translated to USD at $1 USD: 12.91 MXN.


Sanluis’ margins have cooled off a bit since 2009 and 2010, but have stabilized at levels comparable to US-based auto suppliers. For the first quarter of 2014, Sanluis reported EBITDA of USD $30.8 million. This increase came solely from strong activity in North America, as EBITDA at the company’s Brazilian subsidiary fell 48% year over year as the Brazilian economy slowed. At this pace, Sanluis is on track to produce USD $123 million in 2014 EBITDA. I expect quite a bit more, as the US market for pickups continues to improve. Any improvement in Brazil’s results would simply provide an additional tailwind, though I don’t count on it in the short run.

Improving Balance Sheet

Below is a chart of Sanluis’ net debt in recent years, and multiple of trailing EBITDA that it represents.


Since peaking in 2010, Sanluis’ net debt has been reduced by 42.2% in absolute terms. More importantly, net debt has fallen from 5.99x EBITDA to only 1.89x on a trailing basis. If we annualize first quarter results, the company’s net debt is only a hair over 1.5x EBITDA, a thoroughly sustainable level. Sanluis has accomplished this improvement in its financial footing mostly via dramatic increases in revenues and earnings, but also by dedicating the majority of its free cash flow to debt reduction. For fiscal 2010 to 2013, Sanluis produced a total of USD $168 million in free cash flow and reduced gross debt by USD $113 million. Slightly over 44% of Sanluis’ gross debt comes due in December, 2014, but I expect the company to have no trouble refinancing the debt on as good or better terms, give then substantially better operating performance the company has produced since the original debt agreement was reached. The company’s next series of debt comes due in 2017.

Now that Sanluis is on sustainable financial footing, it will be free to dedicate its free cash flow to growth investments or payments to shareholders.


Due to the growth of the US market for pickup trucks, Sanluis’ results are highly likely to rise in coming quarters. For the sake of conservatism, let’s annualize Sanluis’ first quarter results to arrive at a yearly estimate of EBITDA and EBIT. Based on the first quarter of 2014, Sanluis is poised to report $123 million in EBITDA and $96.7 million in EBIT for 2014. However, these figures are slightly misleading. Sanluis has a 50.1% stake in its Brazilian subsidiary, which causes those results to be consolidated under standard accounting principles. However, half of the subsidiary’s EBITDA and EBIT doesn’t actually “belong” to the parent company. By the same token, half of the subsidiary’s debt must be taken out of the equation to arrive at a true measure of enterprise value. My calculation of the company’s liabilities included in enterprise value also bears some explanation.

  • EBITDA and EBIT: Sanluis’ Brazilian subsidiary is called “Autopecas.” This business produced USD $4.0 million in EBITDA in the first quarter. The EBIT figure was not disclosed, but assuming the same margin as the company as a whole, Autopecas would have produced USD $3 million in EBIT. (In reality, it was probably lower as the sting of negative operating leverage was felt.) Annualizing these results reduces Sanluis’ estimated 2014 EBITDA by USD $8.0 million and its EBIT by USD $6.0 million.
  • Net Debt: The Brazilian Autopecas segment has USD $12.8 million in debt. Adjusting this figure for Sanluis’ 50.1% stake in the business results in a USD $6.4 million reduction in net debt. Autopecas likely also has some subsidiary-level cash, but this figure is not disclosed and I’ll ignore it. I’ve been fairly conservative in all my other assumptions.
  • Pension deficit: Sanluis reports a pension deficit of USD $23.2 million, which I add to enterprise value. In most cases where a pension is involved, it is important to look at the assumptions involved. Sanluis uses an expected return of 7.5% on its plan assets. With a high-quality Mexican corporate bond index currently yielding 5.30%, the return figure is in the realm of reasonability. Other important figures like the assumed discount rate and expected salary increases are also reasonable.
  • Special Tax Liability: In late, 2013, Sanluis was hit with a large increase in taxes payable due to a change in the Mexican tax code. These new taxes payable sum to USD $52.8 million and must be paid over the next five years. Using a discount rate of 10%, I’ve included the tax liability in enterprise value at a present value of $41.8 million.

After all those adjustments, Sanluis’ projected 2014 valuation looks like this.


At 4.8x projected EBITDA and 6.1x projected EBIT based on very conservative assumptions, Sanluis is about the cheapest auto supplier I’ve found. This despite Sanluis’ prime industry positioning in the hot market of pickup trucks. The market seems to be catching on to Sanluis’ progress, and shares have rallied quite a lot over the past few months. However, I think they have quite a way to go before they begin to reflect reasonable valuation multiples.


Though the company appears very cheap to me, Sanluis is not without its share of risks. The company has been through two separate rounds of restructuring in the past decade. Sanluis is far larger, more profitable and less leveraged than it has been at any point since its troubles, but “this time it’s different” are famous last words in the investing world. Though the company’s finances (and those of its customers) appear strong at present, a return to a deep recession with an accompanying decline in vehicle sales would hurt Sanluis. Currency risk is also a factor. Sanluis earns the majority of its revenues in USD, but its debt is denominated in Mexican Pesos. A strong US dollar is great for Sanluis, while a strong Peso reduces earnings. (Interestingly, this fact also provides somewhat of a natural hedge for US investors in Sanluis. Though a strong Peso would hurt the company, it increases the value of Peso-denominated investments. The opposite is also true. A weak US dollar benefits Sanluis’ earnings and debt position, yet it decreases the value of Peso-denominated investments.)

There’s a lot more to the story with Sanluis, but that’s quite enough verbiage for now. I always welcome discussing any company I write about with readers, so feel free to drop me an e-mail or leave a comment.

Alluvial Capital Managment, LLC holds shares of Sanluis Corp. SAB de CV  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.

Pental Limited – PTL:ASX

The market values companies from various economic sectors at widely different multiples of earnings, assets and cash flows, and for good reason. In general, non-cyclical sectors receive higher valuations, while industries that are strongly exposed to the business cycle receive lower valuations. It’s a function of cost of capital; industries with deeply cyclical and/or unpredictable revenues and earnings are riskier, and therefore carry a higher cost of capital. Finance 101. One of the most stable market sectors is consumer staples, and that stability is usually reflected in the valuations of companies selling ordinary, necessary products.  Manufacturers of toothpaste, soap, cereal, and like products deserve their premium valuation, because consumers will continue to purchase these products in all but the most extreme economic climates.

For this reason, I pay particular attention when I find a healthy consumer staples company trading at a large discount to market averages, let alone the premium valuation that its peers receive. Today’s example is Pental Limited. Pental is an Australian manufacturer of several household brands, including White King bleach, Huggie fabric conditioner, Martha’s wool cleaner and AIM toothpaste, among other brands. Most of Pental’s products are well-known in Australia and New Zealand and command high market share. Household cleaning is Pental’s leading product category, followed by private label products, then personal care products.

Pental has a broad set of quality product offerings, little debt and reasonable operating margins, yet the company trades at a single digit P/E and a discount to book value. In my view, this humble valuation is caused by two major factors.

Outdated Market Perceptions – Until recently, Pental was a highly distressed and indebted company. Then known as Symex, the company operated a specialty chemicals business in addition to its household products business. The chemicals business once produced substantial profits. However, 2012 saw earnings hammered by rising input costs, a strong Australian Dollar, and strong competition. Symex’s large debt load suddenly threatened the company’s existence. At June 30, 2012, Symex carried AUD 59.70 million in net debt, more than ten times the fiscal year’s EBITDA. As part of an agreement with its bankers, Symex agreed to take a number of steps to reduce its debt, including selling off real estate holdings, raising equity capital, and securing receivables financing.

By the end of 2012, the company (now renamed Pental) had succeeded in raising AUD 17.55 million in equity capital, closed down the specialty chemicals business and sold associated real estate, and made principal repayments on its debt. In return for succeeding with these initiatives, the company’s lender wrote off AUD 10 million in debt. The company secured a new credit agreement expiring in 2015. The company also reported improved profitability in its consumer products business.

Today, Pental has reduced its net debt to just AUD 4.70 million, less than half of trailing EBITDA. Consumer products sales and earnings are on the rise, and the company is constructing new bleach manufacturing facilities, which should reduce costs and increase capacity. The market, however, still treats Pental as the heavily indebted and struggling company that is was a year ago.

Capital Structure – In order to fund its equity capital raising, Pental undertook multiple initiatives. The first was a simple share sale to a strategic investor. Concurrent with the share sale, Pental made a rights issue to its shareholders of seven purchase rights per share. These rights, allowed the purchase of one Pental share at AUD 0.015 per right. Three months after the expiration of these rights, Pental distributed one “loyalty option” for each four shares of Pental, which entitled investors to buy one share of Pental for AUD 0.02 for the following 18 months. Finally, Pental encouraged holders of these loyalty options to exercise the options by distributing “Piggyback Options.” For every loyalty option exercised before November 30, 2013, Pental issued one “Piggyback Option.” These piggyback options allow the purchase of one share of Pental at AUD 0.03 for the following 18 months.

Complicated enough?  After all those moves, Pental has 1,504.58 million shares outstanding. It also has 87.61 million loyalty options still outstanding with a strike of AUD 0.02, plus 287.57 million piggyback options with a strike of AUD 0.03. Estimating a fair value for Pental’s shares requires adjusting for options exercise, which may obfuscate Pental’s worth.

For the twelve trailing months, Pental reported adjusted EBITDA of AUD 10.66 million and EBIT of AUD 9.11 million. (Results in the first half of fiscal 2014 were substantially improved over the first half of 2013, but I’ll refrain from annualizing these in the interest of conservatism.) Reported net income from continuing operations was AUD 4.97 million for the trailing twelve months. Computing Pental’s trailing valuation requires adjusting for the exercise of Pental’s loyalty options. At Pental’s current share price of AUD 0.027, the piggyback options are anti-dilutive. Full exercise of the loyalty options would raise AUD 1.75 million in cash for Pental.


4.3x EBITDA and 5.0x EBIT is a bargain valuation for a growing consumer staples company with little debt and market-leading products. Moreover, Pental’s already conservatively-estimated results are likely to improve once its new or upgraded production facilities are fully online. Already, the company has won new private label production contracts for Woolworths, Aldi, and Coles on the basis of its new, more efficient bleach plant.

Were the market to value Pental at a more conventional multiples of EBITDA, Pental shares could see significant appreciation. The chart below displays potential share prices and appreciation at various EBITDA multiples, assuming full options exercise. Worth noting is the fact that many other basic consumer products producers currently trade at double-digit EBITDA multiples.



Pental is considering reinstating its dividend in 2014, which could lead investors to take a second look at the company’s much-improved balance sheet and improving profits. The company’s loyalty options expire in late 2014, which will serve to simplify the capital structure and will further reduce net indebtedness. Combined with continued revenue and profit growth, Pental shares could be significantly higher a year hence.

Alluvial Capital Managment, LLC does not hold shares of Pental Limited  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.

Holland Colours NV – HOLCO:Amsterdam

Holland Colours (“Holco”) is a tiny Dutch manufacturer of industrial coloring agents and pigments. The company has high employee ownership, operates in a profitable niche market and produces consistent free cash flow, all things I love to see in a company. Holland Colours also trades at a undemanding multiple of earnings, pays a generous dividend and has room for growth.

Holland Colours was founded in 1979 in Apeldoorn, Netherlands. The company’s first product (and still its major source of revenue) was Holcobatch, an easy to use coloring agent for use with plastics and other synthetic materials, especially PVC. Holcobatch can be used to create practically any color imaginable, and is simpler to handle than powder pigments and liquid dyes.



Holland Colours also produces Holcoprill for other plastics and Holcosil paste for silicone products. The company’s largest customer is the construction and building industry, which uses the company’s products to colorize PVC pipes, door and window housings, siding and other plastic components. Holco’s products are also used in packaging, as well as in silicones and elastomers like sealants and  rubber, and finally in specialty applications like polystyrene foams and fibers. Since its founding, Holland Colours has grown into a worldwide company employing around 400. The company has manufacturing facilities in the US, Europe and Asia. Holco’s product lines are not long-term high-growth industries , but demand should generally increase in line with world GDP over time. As always, low long-term growth is neither automatically good nor bad. Low growth limits potential company profits, but also discourages new suppliers from entering the market and reduces the chances of innovative disruption.

The financial crisis took a toll on Holco’s revenues and earnings, but the company has fully recovered. The company manages a healthy gross margin in the mid 40s, and also converts an impressive proportion of its net income to free cash flow. Here’s a look at the company’s results since 2007. All figures are in millions of Euros, and will be for the entirety of this post.


Trailing twelve months results remain slightly below 2011 earnings, when some pent-up demand combined with low materials costs gave Holco some additional earning power. However, the company’s EBIT margin has nearly caught up with pre-crisis figures. From 2007 through fiscal 2013, total net income to free cash flow conversion was 148%, with EUR 16.3 million in free cash flow from EUR 11.0 million in net income.

So where did all that excess free cash flow come from? The answer can be found by comparing Holco’s historical depreciation and amortization with its historical capital expenditures. From 2009 to 2013, Holco seemingly underinvested in its long-term assets, with annual capital expenditures coming in well below recorded depreciation and amortization. Ordinarily, this might be cause for concern. After all, a company that continually underinvests in necessary physical assets will eventually see its competitive and financial positions eroded through production delays and costly repairs. But I don’t think that’s the case with Holland Colours. For one, the company’s main source of revenue, the European building and construction industry, has struggled mightily for the past several years. In times of low utilization, physical plant wears out more slowly and may not require replacement at the same frequency. Second, Holcobatch production has been going on for decades, and the process is unlikely to change, requiring new machinery or facilities. Combine depressed utilization and a stable production process and you get low capital expenditure requirements. Regardless, Holco management has now reversed the low capital expenditure trend, investing 1.15x the amount of depreciation and amortization in capital assets for the twelve trailing months.

Holco has used its copious free cash flow to chip away at its debt, resulting in a much more stable and sustainable company. Should another crisis or extended recession come along, Holland Colours will likely fare much better than it did the last time around.

Now for a look at Holco’s valuation. As I write, the company has a market cap of EUR 25.8 million. However, only about EUR 5.8 million worth of shares are free floating. Just over half the company’s shares are controlled by Holland Pigments BV, in which many Holco employees are invested. (In all, Holco employees own 21% of the company.) Various other institutions own large blocks of shares, leaving only 22.6% of the company’s shares available for investment. The micro float of an already microcap company may partially explain Holland Colours’ low valuation.


Generally speaking, buying consistent free cash flow generators with defensible business models at single digit EBIT/earnings multiples tends to work out well, whether or not a company experiences revenue growth. Either revenue growth does occur, operating leverage kicks in and the value of the company increases without multiple expansion, or market perception changes, and the company is awarded a higher multiple of the same steady earnings and cash flow. Ideally, both processes occur at the same time, and that’s where investors can really make some great returns. At the moment, Holdco’s valuation may be held back by the market’s perception of its home Eurozone economy: financially strapped, with little growth and with no recovery in building and construction within sight. However, Holland Colours actually generates more than 75% of its EBIT in the healthier economic climates of the Americas and Asia.

Year by year, Holco has been reducing its dependence on the struggling markets of Europe and building its business in the Americas and Asia. While the company still receives more than half its revenues from Europe, this figure is down substantially from 2008. Asia’s contribution to revenues nearly doubled from 2008 to present, while the Americas rose slightly.


While Europe’s significance to Holco’s revenues has decreased, the region’s significance to EBIT has truly plunged. In 2008, Europe accounted for over half of Holland Colours’ EBIT; now, it account for less than one quarter. The Americas (chiefly the US and Canada) have come on strong and now account for more than half of Holco’s EBIT. Asia contributes more, but not in proportion to its revenue growth. Holco has had some sales and profitability issues in China, but is attempting to address these through better staffing.


While Holco’s European operations struggle to earn an EBIT margin of more than a few percentage points above breakeven, the Americas segment is ticking along at an EBIT margin of 11.9%, while Asia is at 13.5%. There are a few possibilities here that could result in greatly improved profits for Holco.

  1. Europe continues to struggle, but Holco’s focus on Asia and the Americas continues to pay off. European revenues soon dip below a 50% share and continue to fall, eventually leading the market to recognize that Holco should no longer be given a Eurozone valuation.
  2. Europe’s long-awaited economy recovery arrives, complete with a resumption of normal building and construction activity. European revenues and profitability take off, complementing the company’s successful international operations.

Either scenario would result in greatly expanded profits and likely, a large increase in the value of Holco stock. On the other hand, slowdowns in Asia and the Americas with a continued European malaise could result in returns to 2008/2010 level results, though Holco’s lower indebtedness would somewhat reduce the sting this time around. While they wait to see which scenario plays out, investors will be well-rewarded in dividends. At the current price of EUR 30, Holland Colours yields 5.7%.

Alluvial Capital Managment, LLC holds shares of Holland Colours NV for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.


An Unlisted Eccentric – ACMAT Corp. ACMT/ACMTA

One of the reasons I so enjoy the unlisted markets is the opportunity to discover and examine some truly odd and unconventional stocks. Where else in the public markets can one invest in a massive and secretive agricultural empire (J.G. Boswell Co. BWEL), a minor league baseball team (Rochester Community Baseball Inc. RCCB)  or even extensive real estate, timber, energy and mineral assets in Michigan or Tennessee (Keweenaw Land Association, Ltd. KEWL and Coal Creek Company CCRK)? It’s tough to get bored.

ACMAT Corporation qualifies as one of these eccentric companies. ACMAT is a national provider of surety bonds for the construction industry. Surety bonds are purchased by builders and contractors by necessity. These bonds are sold by insurers, who agree to pay damages in the event that a contractor fails to complete a contract to the agreed specifications or otherwise fails to perform. After all, nobody wants to award a contract to a construction firm without having recourse should that construction firm go bankrupt with the building halfway complete. ACMAT specializes in providing bonding for non-standard contractors who otherwise would have difficulty securing coverage from conventional surety bond underwriters. That may sound risky, but the truth is that ACMAT is an exceptionally conservative underwriter. In 2012, ACMAT’s loss ratio on premiums was only 10%, and 11% in 2011. That kind of underwriting would be a recipe for amazing profits, but the company uses only a scant percentage of its total underwriting capacity. In the 2012 annual report, the company noted that it could increase premiums more than 20 fold before breaching NAIC guidelines. Due to its conservatism and history of profitable underwriting, A.M. Best rates the company at “A” or excellent.

ACMAT is an insurer that scarcely bothers to insure. In fact, premiums written have declined 85% from a high of $15.7 million in 2004. The company expresses a willingness to increase its activity once the construction market picks up, but it is unlikely that any increase will approach previous levels of underwriting activity. ACMAT’s current asset base is 47% lower than it was in 2004, and its equity is 25% lower.

As conservative and limited in scope as ACMAT’s insurance operations are, the company could hardly be more aggressive when it comes to returning capital to shareholders. ACMAT is a voracious purchaser of its own shares. ACMAT’s formal share repurchase operation was begun in the 1980s, and the company has had a laser focus on reducing its share count ever since. Since 1994, the company has reduced its shares outstanding by a whopping 73%, hoovering up an average of 6.7% of shares outstanding each year. Since 2009, the pace has accelerated to 8.3% per year. A yearly chart of shares outstanding and book value per share is presented below.


From 1994 to the present, ACMAT spent a little more than $77 million on net share repurchases, a figure that is more than four times the company’s current market cap. The repurchases were done at an average price-to-book ratio of 1.05.

At this point, I’d love to talk about how ACMAT’s share repurchases were some Templetonesque example of superior capital allocation policy and how shareholders have enjoyed high teens level returns for decades on end. Unfortunately, I can’t, because ACMAT’s returns have been awful, and that’s putting it gently. Since the end of 1994, shareholders have seen their investment in ACMAT’s class A stock rise by…..151%. Over the same period, the S&P 500 (in terms of SPY) returned 481%. Even the Barclays Aggregate Bond Index returned around 221%. There’s no excusing such a poor long-term performance. ACMAT’s return on equity has consistently failed to match its cost, costing shareholders millions.

It goes to show that for as much as value investors love to trumpet the benefits of share repurchases, they aren’t magical. Satisfactory long-term returns require a comprehensibly sensible capital allocation policy that strives to earn an acceptable return on equity. ACMAT shareholders would have been much better off if the company simply liquidated in 1994, rather than spending the next two decades earning anemic returns on equity. Even today a liquidation would be very beneficial. Company shares trade at a large discount to book value and the company seems unlikely to earn an attractive return on equity any time soon.

But of course, that will never happen due to ACMAT’s thoroughly entrenched insiders. CEO Henry W. Nozko and his wife Victoria C. Nozko together own a majority of shares outstanding and control nearly all of the voting power. The last available compensation data for Mr. Nozko is from 2003, where he earned a salary and bonus of $732,000. This may not seem like much, but it equaled fully 29% of ACMAT’s pre-tax income for the year. The company’s top three officers earned an amount equal to 62.5% of ACMAT’s pre-tax income for the year. This data is old, but I see little reason why anything would have changed in the last decade, especially now that the Nozkos control even more of the company’s shares through the continued repurchases. Company management also seems prone to vanity projects, including the construction of a brand new headquarters at a cost of $4.3 million in 2012.

That brings me to the second point of this post: management matters. And it matters especially with insider-controlled micro-cap companies, where the major institutions and activists that keep large company management teams nominally in check are absent. Management teams at large companies can and frequently do make bad capital allocation decisions, overpay themselves and pursue vanity projects. But if they do it for long enough, they are typically challenged and either chastened or removed altogether. There is rarely such a check on the tiny and obscure companies that populate the world I play in, and that makes management evaluation all the more important. Some like to talk to management directly and ask questions about strategy, assess ethics, etc. That works for them, but I reason that shoddy or dishonest managers are pros at knowing what investors want to hear and saying exactly that. I’d rather look at what they do. Managers prove themselves to me by aligning their interests with shareholders, then showcasing their skill and trustworthiness by creating track records of efficient operations, astute capital allocation decisions and reasonable compensation.

Perhaps if ACMAT’s management team gets serious about improving returns on equity and equally serious about reducing its cost structure, ACMAT will be an attractive investment. But for now, it’s just another unlisted oddity.

Alluvial Capital Managment, LLC does not hold shares of ACMAT, Inc. for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.

ELXSI Corp.’s Outlook is Bright, But Who Will Benefit? – ELXS

ELXSI Corp. has been on my radar screen for years. The company’s primary subsidiary is a fast-growing, very profitable business in an industry with a great demand outlook. The company’s less-profitable subsidiary is winding down and becomes less and less relevant as time goes by. Gross margins, operating margins and returns on capital are all reaching new heights, and the company has built a solid cash buffer. With all those positive dynamics in place, just what is it that has kept me out of ELXSI? The answer is one word, the same word that keeps me out of many otherwise attractive small companies: management. ELXSI’s history is riddled with exploitative related-party transactions that have resulted in a massive value transfer from ELXSI’s minority shareholders to company insiders. More on that in a bit. For now, let’s examine ELXSI’s corporate history.

A decade ago, ELXSI was a struggling restaurant operator with minor manufacturing operations in Florida and a retail store installation business in Illinois. The company had purchased 30 Bickford’s and Howard Johnson’s restaurants from Marriott Family Restaurants, Inc. in 1991, but changing trends in the restaurant industry and ballooning costs caused the company’s operating income to erode, turning negative in 2004. Realizing that most of its restaurants were beyond rehabilitation, the company spent the next several years shutting down or selling off properties. In 2007, the company shut down its retail installation business after losing a significant client.

Today, ELSXI operates only six restaurants in Massachusetts and New Hampshire, and leases three restaurants to third parties. Restaurant revenues accounted for 62.9% of total turnover in 2004, but only 11.1% in 2013. While the restaurant segment is a shadow of its former size and importance, the company’s manufacturing operation has become a force. Cues Inc. is the name of the business, and its success has completely changed the picture for ELXSI. Cues manufactures robots and systems for use in inspecting pipelines, especially sewer lines, water lines and industrial process lines. Cues has grown its top line at 5.9% annually for the past decade, and now accounts for the great majority of ELXSI’s revenues, earnings and assets.

The outlook for Cues’ products is bright. American water and sewer infrastructure has suffered under-investment for generations and is approaching a critical state. Water mains one hundred years or older are still in use in many areas, and some cities still rely on pipes made of obsolete materials, even wood . (In all fairness, it seems that wooden pipes actually have quite a long useful life, though they require quite a lot of expertise to repair.) In my view, products that enable inspectors, engineers and others to evaluate existing infrastructure will be more necessary than ever in coming decades. Of all the various types of infrastructure, water delivery and treatment systems are among the most critical and most need of investment, and Cues will benefit from that trend.

Cues’ success and the winding down of the unprofitable restaurant segment has allowed ELXSI to more than double its EBIT since 2007, even as sales fell 10.7%. Never underestimate the power of expanding margins! Indeed, ELXSI posted an EBIT margin of 7.7% in 2013, a great improvement over the 1.2% EBIT margin “achieved” in 2007. Here’s a look at ELXSI’s results for the last decade.



As ELXSI’s profits have risen, so has its efficiency. The company now generates a respectable NOPAT/Average Invested Capital ratio of over 15%, compared to a the single digit or negative figures of years past. The company’s balance sheet is strong, with net cash of $2.4 million.

Despite the greatly improved profitability and healthy outlook, the market affords ELXSI only a modest valuation.



There’s a lot to like about ELXSI. Improved and improving operating measures, a conservative balance sheet and a bright revenue outlook, all at a bargain basement valuation. However, there’s more to the story. I believe the company’s low market valuation is largely due to a large perceived off-balance sheet liability: the possibility that management will continue to extract value from the company that rightfully belongs to shareholders. Just take a look at a few of management’s past actions:

  • Loan number 1: ELXSI loaned $1.16 million to ELX Limited Partnership, an entity wholly-controlled by ELXSI’s chairman, president and principal shareholder, Alexander M. Milley. ELX used this loan to purchase 369,800 shares of ELXSI stock from a third party (famed investor and businessmen Peter Kellogg.)
  • Loan number 2: ELXSI loaned another $909,000 to ELX, to be used to purchase 110,200 shares of ELXSI Corp, again from Mr. Kellogg.
  • Loan number 3: ELXSI loaned $2 million to Cadmus Corporation, an Alexander M. Milley-controlled corporation.
  • Loan number 4: ELXSI loaned another $6.73 million to Cadmus corporation.

In total, ELXSI loaned $10.8 million dollars to entities controlled by its chairman, in part so the chairman could purchase company stock. That is a LOT of capital used to enrich the chairman at the expense of shareholders. And guess what? ELX and Cadmus never even paid the minimal interest expenses accrued on the debt. In 2013, ELXSI forgave the entire balance, both principal and accrued interest, in return for 486,990 of its own shares worth $4.55 million. For those keeping score, that’s a net loss to shareholders of $6.25 million, not including millions in accrued interest and opportunity costs.

In return for the loan forgiveness, Cadmus Corporation also agreed to terminate its management contract with ELXSI. Oh, did I forget to mention the management contract? Since 1989, Cadmus and ELXSI had an agreement specifying an escalating management fee, payable in years where ELXSI’s operating income exceeded $4 million. ELXSI had not paid the management fee for the last few years, letting it accrue. In 2013, ELXSI paid Cadmus $3.12 million to settle the accrued fee and terminate the contract. You read that correctly. Despite shorting ELXSI $6.25 million in principal value on the debt settlement, Cadmus and ELX  somehow still received $3.12 million in cash to settle the accrued management fee.

As a final insult, on January 1, the company agreed to issue Alexander M. Milley 80,000 shares of stock in each of the next five years, providing the company earns at least $4 million for the year. As a result, Mr. Milley is likely to receive back nearly all of the shares his companies conveyed to ELXSI for debt settlement.

Perhaps the days of the worst shareholder abuses are past, but the potential remains for additional value transfers to management at the expense of minority shareholders. For that reason, I’m staying away from ELXSI. It’s a shame, really. I’ve love to own some shares. But when I invest in a company, I need to be confident that my proportional share of earnings and cash flow will accrue to me. With ELXSI, I simply can’t be sure.

Alluvial Capital Managment, LLC does not hold shares of ELXSI Corp.  for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.

Northern Offshore – Market Fails to Notice Upcoming Rise In Earnings, Free Cash Flow

My most popular series of posts by far have been those on Awilco Drilling. Awilco has been a solid investment, providing a total return of over 70% since I first wrote about the company last May. Despite these results, the company still trades at a dividend yield of close to 22% and an EV/EBITDA of 4.1, and I believe the shares still have a lot of room to run. Today’s post is about a similar high-yielding company in the same industry. This company is reminiscent of Awilco a year ago, when the market had yet to price in the coming increases in earnings and cash flow from new contracts.

Northern Offshore owns a collection of marine drilling assets, including two jackup rigs, a semisubmersible rig, a drillship and a floating production unit. Northern is domiciled in Bermuda with its executive offices in Houston, and trades on the Oslo exchange as “NOF.” (There is also a US ADR, NFSHF, though trading volume is thin.) Northern’s assets are leased to drillers and explorers in the North Sea, Asia and soon, Africa.

Compared to Awilco’s stellar management team, Northern has not always enjoyed the same leadership quality. Struggling with an unmanageable debt load, the company underwent a reorganization in 2005 that included a share issuance and a brand new board of directors. Unfortunately, the new team made a massive and debt-financed $455 million acquisition in 2007. The acquisition was poorly-timed, and in 2010 the jackup rigs the company acquired were written down by $205 million. Despite the unfortunate transaction, Northern managed to stay current on its debt and eventually paid down the balance. Today, the company has a net cash position.

Let’s take a look at Northern’s active operating assets. Like Awilco, these assets are hardly new, yet they still have a reasonable lifespan and will produce a great deal of cash flow over that life.

Northern Producer

Northern Producer is the company’s floating production facility, currently operating in the North Sea. Northern Producer was originally contracted as a semisubmersible drilling rig in 1977 and converted to a floating production facility in 1991. Northern Producer is contracted to EnQuest for the life of the oil field, and earns revenues based on production levels. In 2013, Northern Producer earned tariffs on an average of 18,103 barrels per day and earned just over $40 million in revenues.

Energy Driller

Energy Driller is Northern’s semisubmersible drilling rig, originally constructed in 1977. The rig has undergone substantial upgrades, most recently in 2012. Energy Driller in contracted to ONGC off India’s west coast at a dayrate of around $210,000 until April 2015. Energy Driller has historically operated off of  Southeast Asia and Brazil. In 2013, Energy Driller earned revenues of just under $58 million.

Energy Endeavor and Energy Enhancer

Energy Endeavor and Energy Enhancer are Northern’s harsh environment jackup rigs, currently operating off of the Netherlands and Denmark by Wintershall and Maersk, respectively. Endeavor is contracted until November 2014 at a dayrate of around $160,000. Wintershall has an option to extend the contract by six months. Enhancer is contracted until July 2015 at a dayrate of around $140,000. Maersk has a one-year option to extend the contract at a higher rate. Both Endeavor and Enhancer were constructed in 1982. In 2013, Northern’s jackup rigs brought in revenues of nearly $77 million.

Northern has two new jackup rigs on order to be delivered in 2016. More on these a bit later on.

In 2013, Northern Offshore’s active assets earned $174.9 million revenues, and produced $50.4 million in EBITDA and net income of $11.3 million. Free cash flow was $30.2 million, which the company devoted entirely to paying dividends. Based on its current market capitalization of $238.6 million, Northern’s valuation seems attractive.



One could see the EV/EBITDA multiple of 4.5 and the double-digit free cash flow yield and conclude that Northern is cheap, but that would be some very lazy analysis. After all, drilling companies face some unique challenges. Drilling companies must engage in significant capital expenditures, lest their assets become too old or degraded to have any economic value. Drilling companies are also subject to fluctuations in dayrates, and risk revenue declines once contracts end. For those reasons, buying drilling companies purely on backward-looking EBITDA or free cash flow yield can be a losing proposition.

However, at some point, the free cash yield becomes high enough or the EBITDA multiple low enough to adequately compensate for these factors and then some. This is likely to be the case for Northern Offshore in 2014. Remember how I described Northern’s active operating assets and their revenues? I used the term because Northern has another very significant asset, one that sat idle for all of 2013.

Energy Searcher is Northern’s drillship, used in exploration activities. The ship completed a contract earlier than expected off Vietnam in 2012, and was sent to Singapore for maintenance after. Northern Offshore marketed the ship for the entirety of 2013, but could not find a taker. Finally, Northern has signed a contract with Camac Energy for use off Africa’s west coast, and at a handsome rate: nearly $100 million per year, with an option for an additional year. The ship is currently on its way to its new market, where it will begin operations in mid-2014. The revenues from this contract should add handsomely to Northern’s EBITDA and free cash flow.

Before I proceed to evaluate the impact of Energy Searcher’s contract, a few caveats. First, Energy Searcher is an OLD vessel. Rigzone.com and other shipping info sites list the date of construction as 1982, but some other sources indicate that Energy Searcher was originally built in Sweden in 1958 and converted to a drillship in 1982. Apparently, the original engine is still going strong, but anyone wishing to model out Northern’s results should probably not assume a long remaining life for Energy Searcher. Second, Northern’s troubles marketing Energy Searcher are not new. The ship also sat idle for much of 2011. Finally, Energy Searcher’s new employer, Camac Energy, is hardly a prime operator. Camac is a highly speculative prospector that recently required a capital injection from a South African pension fund to continue its operations. Should Camac run into further trouble, its ability to perform on the Energy Searcher contract could be in doubt.

Assuming all goes well, Energy Searcher will provide a serious boost to Northern’s operating results. In previous years, drilling and production costs have ranged from 40.7% of revenues all the way to 71.1% of revenues.



Conservatively assuming that drilling and production expenses eat up 70% of Energy Searchers’s revenues, Energy Searcher will contribute an additional $30 million or so to Northern’s EBITDA and free cash flow once the contract kicks in. The chart below compares Northern’s actual 2013 results with pro forma results including Energy Searcher’s revenues. The projection ignores increased revenues from a higher dayrate for Energy Enhancer and assumes general and administrative costs remain steady.


Once Energy Searcher is again in operation, Northern’s EBITDA and EBIT will likely jump significantly. Free cash flow will likely rise by a similar amount, though some working capital investment may blunt the effect slightly. Regardless, 2.8x pro forma EBITDA and 4.7x pro forma EBIT is flat out cheap, even for a company that faces distinct risks.

Complicating the matter is Northern Offshore’s order for two high specification jackup rigs, currently being built in China for delivery in 2016. Northern Offshore will require financing for the total cost of just under $180 million. Northern Offshore will have a few financing options available, including a bond issue, a sale-leaseback arrangement with  a company like Ship Finance or Ocean Yield, or selling off its existing assets. Whether the new jackup rigs will be a profitable investment is another question, and one that is difficult to determine two years in advance. Much depends on the direction of oil prices and jackup dayrates in the interim.

Despite these risks, I contend that the market has failed to adequately price in Northern Offshore’s upcoming EBITDA and free cash flow boosts. Once the market notices the absurd EV/EBITDA multiple and the 20%+ free cash flow yield that the Energy Searcher contract could bring, shares could appreciate, much like Awilco’s did once its rigs were fully contracted and operating. In the interim, shareholders will be well-compensated by Northern Offshore’s 14% dividend yield.

Alluvial Capital Managment, LLC does not hold shares of Northern Offshore  for client accounts. Alluvial does hold shares of Awilco Drilling for client accounts.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. For information on Alluvial’s managed accounts, 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.