Lessons Learned

In the comment left on my last post, a reader suggested I discuss what I’d learned from the performance of the stocks mentioned in my earliest blog posts at the beginning of 2012. I thought that was a good idea. With the benefit of hindsight, it is clear where my analysis of the various stocks contained solid reasoning and great foresight, and where it most assuredly did not. I present five lessons I have taken from my progress as an investment practitioner.

Normalize, Normalize, Normalize

Nearly every value investor has a story of discovering a company trading at low, low multiples of cash flows and earnings and buying in, only to see earnings and cash flows begin a steep decline. What looked like a bargain based on current profits was actually fairly-priced or even over-valued based on forward-looking profit measures. Conversely, nearly every investor can remember passing on a company due to high valuation multiples, not realizing that earnings and cash flows were about to explode as the company’s economic outlook improved. These cases illustrate the risks of valuing cyclical companies using peak or trough results. Great danger lies in assuming good times will last indefinitely, and also in assuming bad times will do likewise. Excepting cases where demand for the company’s goods or services is likely to remain in decline (newsprint, wireline telecom, most types of coal) or likely to grow at an above-average rate for long periods to come (healthcare, data and data services) investors are well-served to estimate mid-cycle earnings and cash flows and use those as the basis for valuations, not current results. Homebuilders, shipbuilders, construction, and semiconductors are all examples of industries that deep boom and bust cycles, and estimating earnings power based on only a short part of the economic cycle is hazardous to one’s wallet.

Knowing this was what lead me to successfully identify Schuff International as an attractive security, though current earnings and cash flows were weak. The financial crisis took an immense toll on construction spending, but I was reasonably sure that Schuff’s profits would eventually rebound. In 2011, Schuff earned only pennies of operating income per dollar of assets employed, but I knew it had once earned far more and believed it would again, one day. As the economy recovered and companies and governments once again launched major building efforts, Schuff’s profits rocketed and so did its share price.

Don’t Sit Across The Table From Management

Not every company I invest in has a stellar management team. Some seem half-asleep, content to let cash pile up on the balance sheet without any clear plan to use it productively. Some have their hands stuffed a little deeper in the cookie jar than I think is fair, and pay themselves excessively. Others are unfocused, choosing to pursue distracting side ventures rather than concentrate on the company’s strong core offerings. All of these I can forgive, so long as the company’s operations are going well and shareholders are being treated fairly. What I can’t accept is when management acts in opposition to shareholders, scheming to deprive them through abusive related-party deals or absurd compensation. I also cannot accept when managerial compensation is totally divorced from performance, allowing management to profit even from outright failure.

I overlooked this possibility when I was analyzing Webco Industries. The company’s financial statements disclosed little, making it difficult to see just how richly management was rewarding itself from quarter to quarter. Furthermore, I failed to see that management had chosen to “bet the firm” on a massive and costly expansion when other steel companies were struggling with weak demand and pricing. Since my post, Webco has struggled to produce sustained profits and remains saddled with a great deal of debt. Despite the poor results, management continues to grant themselves thousands of additional shares each quarter, a huge number for a company with under 1 million shares outstanding. Since my write-up, Webco’s management has granted itself shares worth between $2.4 and $4.5 million, depending on the share price at the time of the grants. In a time period where the share price has been cut in half, management has seen fit to transfer ownership of 4.5% of the company from shareholders to themselves. I’m not saying Webco would have been a successful investment without this compensation. The challenging economics of the steel industry would likely have prevailed. But knowing how management treated shareholders at the time of my investment might’ve made me question just who would reap the benefits of any future profits.

Beware Of Customer Concentration

If a company depends on just a few customers for the majority of its revenues and profits, those customers have significant bargaining power over the company. These customers may be able to win price discounts or better payment terms. If the worst case scenario occurs and these customers end their relationships with the company, financial results can fall off a cliff. This risk is elevated with micro-cap companies, many of which depend on a limited customer base in a small geography.

QEP Company was severely affected by the loss of a major customer. I rationalized the loss as manageable, believing the company would be able to replace the lost revenues in short order. I should’ve run for the door. Several quarters have gone by and the company has spent millions of shareholder wealth on acquisitions, yet results have not recovered. If I’d properly discounted my estimate of QEP’s worth for its high customer concentration, I may have avoided a costly mistake.

Perception Lags Reality

The stock market is very efficient. New information is almost immediately incorporated into stock prices. The biggest exception to this general efficiency I’ve found is the market for micro-cap and thinly-traded stocks. Information seems to move at a trickle in these market niches, leading to opportunities for sharp-eyed investors. At the smallest and least liquid end of the market, stock prices seem oddly tied to out-dated perceptions of company health and value. Once-distressed companies that have cleaned up their acts trade at low valuations long after the turnaround is in full swing. On the other hand, once healthy companies with trouble on the horizon often retain premium valuations well after the stormclouds have arrived.

When I found Alaska Power & Telecom, the company was only a few years removed from a brush with bankruptcy. The company had shutdown its loss-making operation and had secured new financing, and was making progress in reducing its leverage. Despite this progress, the company traded at a dismally low multiple and offered great value. As the market’s opinion caught up, shares appreciated to a more realistic valuation. Now, who’s to say I wouldn’t have made the same mistake as the market if I’d known of the company in 2010 and 2011? Perhaps the company’s prior difficulties would have colored my analysis and kept me from investing. As investors, we must strive to keep out estimates of value forward-looking and avoid being anchored by past company failures or successes.

Investing Doesn’t Take Place In A Vacuum

As much as some of us would wish it, investing is so much more than a numbers game. Beyond the figures on the financial statements, uncountable factors can influence the success of an investment. Leadership changes, technological and demographic changes, government actions, even weather will influence the companies we buy in profound ways. While many of these impacts cannot be anticipated, investors should attempt to incorporate those that can be into our estimates of company value. Luckily, the SEC requires companies to help us in this task. I am convinced that one of the most valuable sections of any SEC-filer’s annual report is the “risk factors” section. Yet, it is perhaps the least-read section. It’s easy to understand why, as this section is typically full of legal boilerplate and bland, generic verbiage. Yet companies will often disclose threats their business faces that are discussed nowhere in the remainder of the filing or in quarterly earnings calls.

Another early post of mine discussed a metals supplier, Empire Resources. My investment in Empire Resources worked out well, but it would have worked out much better except for government action. When the government failed to renew the General System of Preferences in mid-2013, it resulted in substantial cost increases on raw materials imported from the company’s main suppliers. I gave little thought to the possibility of this negative government action. After all, the company didn’t seem to express much concern in quarterly earnings presentations. But there it is in the company’s 2012 annual report under risk factors:

“During 2011 and 2010 approximately 54% and 42%, respectively, of our purchases of aluminum products were from countries that were considered developing countries whose exports were eligible for preferential tariff treatment for import into the U.S. under the generalized system of preferences or duty free. There can be no assurance that any of our suppliers will continue to be eligible for such preferential tariff treatment or that the generalized system of preference will be renewed after its expiration on June 30, 2013.”

I should’ve built this risk into my estimates of future earnings for Empire Resources. Perhaps I wouldn’t invested anyway, but perhaps some other stock would have looked relatively more attractive, and I could have made more by investing in it instead.

Hopefully this list of concepts and their explanations will be helpful in your quest for the next great stock. Investing is a never-ending learning process, and I owe a great debt to other investors who have taught me lessons along the way.

Again, I’ll be in Toronto April 14-16 for the Fairfax shareholders’ meeting and would enjoy meeting any blog readers who will be in town.

Alluvial Capital Management, LLC may hold shares of securities mentioned 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.

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A Look Back

The other day I realized it’s been three years since I started writing OTC Adventures. That’s a long time in the life of a blog! When I started, I had no idea that my writings on micro-caps, illiquid stocks and other obscurities would find an audience, let alone eventually allow me to launch my own RIA practice. These days nearly all my time is spent in seeking out great investments for my clients, but I still enjoy writing here when I can.

In recognition of how far this blog has come since those first posts, I’d like to look back at the first companies I’ve profiled and see what’s become of them. I’ve learned and grown as an investor since I wrote these posts, but I like to think these early analyses hold up well.

Today I’ll tackle the first five stocks I wrote about.

QEP Company

I wrote up QEP Company on January 17, 2012, when the company traded at $14.25. In the post, I expressed optimism that the company’s strong results would continue and the company would benefit from deleveraging. Well, that’s not exactly what happened. The company wound up losing a major contract and with it, much of its future sales and profits. QEP attempted to make up for the loss with a succession of acquisitions, but as yet, all efforts to return to growth and grow profits have been for naught. Margins are under pressure and trailing EBIT has declined to $5.31 million, down 70% since my post. Perhaps somewhat surprisingly, the stock has risen 18% since my post.

Schuff International Company

My post on Schuff went live on January 29, 2012, when shares changed hands at $9.00. At the time, I cited the company’s large share repurchase, low multiple of normalized earnings and improving industry conditions as reasons the shares would move higher. Shares soon dipped all the way down to $6.50, but then began a steady march higher. Improved operating conditions provided a tailwind, but the biggest gains came when company management sold their majority stake to Phil Falcone’s HC2 Holdings for $31.50 per share. A follow-up tender offer took HC2’s stake to over 90% and it seems like the end of the road for Schuff shareholders, even as many believe the company’s shares are worth twice as much or more than HC2’s purchase price. (Meanwhile, any holders who jumped over to HC2 following the buyout have seen returns of 180% atop the already healthy returns from Schuff shares.) In the end, Schuff shares returned 250%.

McRae Industries

Next, I tackled McRae Industries, writing about the company on February 5, 2012 when class A shares went for $12.77. The family-owned bootmaker was attractive due to its strong balance sheet, healthy demand for both its work/military and Western/fashion boots, and a modest valuation of current earnings. Since the post, McRae’s revenues and earnings have risen at a healthy pace and the stock has followed, though shares still trade at very low multiples, especially considering the more than $20 million in cash and investments the company has accumulated. McRae shares have provided a total return of 168%.

Webco Industries

The Webco Industries post went live on February 14, 2012. (Can you tell I was single at the time?) The stock price at the time was $125. I deemed Webco attractive based on a track record of profitable growth, expansion efforts, and a deep discount to tangible book value. Sadly, it seems that the discount to book value was warranted. Webco finished a major expansion only to find the anticipated demand absent, and profits have been scarce since. Weak steel prices, high leverage and an ever-increasing share count have lead to returns of -48% since my post.

Alaska Power & Telephone

I wrote up APTL on February 23, 2012. At the time, shares went for $17. I was attracted to the company based on its low valuation. By my estimate, the combination of stable telecom and utility assets ought to have merited a much higher valuation. I also appreciated the company’s efforts to clean up its balance sheet and restore credibility following some unfortunate efforts to expand into construction. APTL executed its business plan, paying down debt and restarting a dividend. The company now plans to construct a new hydro-electric plant and build out its data offerings. Shares have provided a total return of 32% to date.

On average, the first five stocks I wrote about returned 84%, which holds up well against the return of the iShares Micro-Cap ETF (IWC) which returned 55% since the end of 2012. As usual with any basket of stocks, a few produced dynamite gains, a few gave a respectable return, and a few were duds.

In many ways, 2012 was an ideal time for micro-cap investors. The immediate danger of the financial crisis had passed, but the market still priced many of these companies for failure, or at least as if they would never grow again. The virtuous cycle of increasing earnings and expanding multiples has provided many investors with excellent gains, but it has also left the ranks of obviously cheap stocks looking very thin. Finding the remaining bargains requires investors to search more broadly, perhaps in foreign markets and unusual securities, and more deeply, picking apart financial statements and industry news to find the value beneath.

In a few days I’ll take a look at how the next set of stocks I wrote about way back when has performed, before returning to “regular programming.”

On another note, I’ll be in Toronto on April 14-16 for the Fairfax Financial shareholders meeting and associated festivities. I’d enjoy meeting blog readers and fellow value investors of any stripe. Let me know if you’ll be in town.

Alluvial Capital Management, LLC holds shares of McRae Industries, 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.

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Granite City Food & Brewery Explores a “Strategic Transaction” – Will Shareholders Benefit?

I’ve happened across an interesting situation in Granite City Food & Brewery, Ltd. On Monday evening, the company released its preliminary 2014 results and also announced it would explore a “strategic transaction.” These words are music to investors’ ears, because they often portend a sale of the business in the near future, or some other value creating action by the company. As I read the announcement, I felt that little twinge of excitement that always arrives when I suspect I’ve stumbled onto something good. The market felt the same thing and bid shares up 27% on Tuesday to close at $1.85, with a bid/ask mid-point of $2.20. While the price rise cooled my interest a little, I was still eager to begin my due diligence, hoping I might find a cheap company ripe for a rich takeover offer.

Turns out things aren’t quite that simple. Granite City’s results are not strong, and the company’s track record is one of mediocrity and missed expectations.

Granite City Food & Brewery is a restaurant company with two different concepts: Cadillac Ranch and Granite City food & brewery. The Granite City concept has 31 locations in the Midwest and Cadillac Ranch has 5 locations: Miami, Indianapolis, National Harbor, MD, Minneapolis and Pittsburgh. The Granite City concept emphasizes a casual American menu and polished interiors heavy on natural materials, and serves the company’s own beer. Cadillac Ranch is a throwback concept that emphasizes roll n’ rock and automotive decor and offers dancing and musical entertainment.

Cadillac Ranch is the company’s newer concept. The chain was founded in 2009 and purchased by the company in 2011. If you think the concept sounds a little uninspired, you’d be right. The restaurant industry is intensely competitive, and success for a new entrant requires both an interesting concept or presentation and good food and drink offerings at the right price point. Come up short on any one of those factors and customers will happily spend their dollars at another of the dozens and dozens of other restaurants clamoring for their business. Unfortunately for Cadillac Ranch, the reviews are in, and they’re not good. The restaurants garner a meager 2.5 out of 5 stars on yelp.com with hundreds of reviews from various locations. Guests repeatedly complain of indifferent staff, cold or mis-prepared food and a cheesy atmosphere. I’m not surprised by the poor rating. There’s a Cadillac Ranch in a shopping center outside my own city, and every restaurant in the whole complex is of the bland, corporate chain variety. Seems right that Cadillac Ranch would offer more of the same.

The Granite City-branded restaurants enjoy much better reviews, but it bodes ill for the company that its newer concept has suffered such a lackluster market reception. The poor results are readily apparent in Granite City’s financial statements. Though revenues grew 41% from 2009 t0 2014, the growth is almost entirely the result of huge investment in new restaurants. Sales per unit actually grew just 14% over the same time period, a period in which restaurant receipts surged as the economy recovered following the Financial Crisis.

Here’s a look at Granite City’s financial statements since 2008. While the company has grown, it hasn’t once produced a profit and has repeatedly sold equity and taken on additional debt to fund its expansion. The figures I’ve presented below look slightly better than the actual statements, because I’ve added back one-time expenses like pre-opening costs to EBITDA and EBIT.

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With results like that, it shouldn’t be hard to understand why the company’s stock has gone nowhere in the last five years. What makes the results more difficult for investors to stomach is how the results compare to management’s own projections. Granite City released a presentation in 2012 projecting its restaurant-level EBITDA would increase by $7-8 million in 2013/2014. The actual results? Restaurant-level EBITDA was virtually flat, even as revenues rose 12.5% from restaurant openings.

With results like these, it’s not surprising that Granite City’s owners are thinking about cashing out and letting someone else enjoy the headaches. So who are these owners, and what kind of price might Granite City fetch?

Granite City is controlled by Concept Development Partners, which is in turn controlled by CIC Partners, a private equity firm. CDP took over in 2011, providing financing in the form of convertible preferred stock. Since then, CDP has received another 482,000 common shares through dividends on its preferred stock, and purchased 3.125 million common shares in a stock offering in 2012. Through its ownership and through a voting agreement with the former majority owners, CDP controls 78% of the voting power of Granite City shares, and holds a 67% economic interest in the company.  Thus far, the involvement has not been profitable. CDP paid $2.37 per share to purchase 3 million shares from the previous controlling shareholder, and paid $2.08 per share to buy an additional 3.125 million shares in 2012. At the current trading price, that’s a loss of about $2.2 million.

So, CDB is seeking to cut its losses and offload Granite City to somebody else. The price that Granite City fetches will depend on the buyer’s belief in its ability to bring the company to profitability and to what degree corporate-level costs (as opposed to restaurant operating costs) can be cut.

At its present bid/ask mid-point of $2.20, Granite City has a market capitalization of $32 million, assuming all convertible preferred stock is converted into common shares. The company has net debt and capital leases of $53 million (as of September 30) for an enterprise value of $84 million. Adjusted 2014 EBITDA was $10 million, and operating income was $2.4 million. I constructed a peer group of other similar restaurant operators with EBITDA below $100 million, to see how Granite City’s valuation compares.

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Granite City Food & Brewery trades about 3 EBITDA turns below the peer median valuation. Then again, a discount is deserved. Granite City is both unprofitable and the most leveraged of all its peers, so it carries a significantly higher risk of financial distress. The leverage ratios for some peers are likely under-stated, since many restaurant companies make significant use of operating leases. However, I doubt anyone would dispute my characterization of Granite City as “highly-leveraged” as a consumer discretionary company carrying net debt and capital leases of 5.3x EBITDA.

Because Granite City is so leveraged, its equity could command a wide variety of market values depending on its EBITDA multiple and potential cost savings. The chart below illustrates various share prices at different EBITDA multiples and corporate cost savings. (The company hasn’t yet released its official 2014 financial statements, so I’ll use 2013’s corporate expenses.

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It’s not tough to get to a share price well above the current price using even modest corporate cost reduction assumptions and an EBITDA multiple at or slightly above the current valuation.

Once again though, it’s not that simple. This multiple and cost savings matrix ignores several other factors that any Granite City buyer would have to consider.

  • Incremental operating capital – Granite City is not profitable. Any potential turnaround would take time, and the company would need a source of additional cash to bridge the losses until breakeven was achieved. Whether equity or debt, an acquirer would have to factor the additional capital requirements into the bid price.
  • Capital expenditures – Cadillac Ranch isn’t working, and any acquirer would have to sink lots of cash into figuring out why not, and then fix the issue. Maybe it’s as simple as a revamped menu, or maybe the chain requires a complete rebranding. The costs could easily run into the millions, and the acquirer would need to reduce its bid accordingly.
  • Long lease terms – many of Granite City’s restaurant locations have lease terms of a decade or longer. This can be a positive or negative factor, but its typically a negative factor for struggling operators. Ordinarily, a restaurant owner dealing with some struggling units could choose to stop the bleeding by boarding up shop and vacating when the lease expires. Granite City does not have that option. Even if the company shut down certain restaurants tomorrow, it would still be on the hook for another decade of lease payments. A company can often negotiate a lump payment for breaking a lease, but it’s yet another cost an acquirer would have to account for if their strategy included shuttering any underperforming locations.

I could go on, but you get the idea. Maybe Granite City will find an optimistic (or naive) buyer willing to pay a high multiple and assume low turnaround costs and big cost savings. In this case, shareholders will make a handsome profit. But maybe acquirers will notice the company’s dismal history, underperforming properties and offer little, expecting huge “repair” costs. I don’t know enough to feel confident one way or the other, and I doubt additional research will lead me to a strong conclusion. And let’s not forget it’s not even a foregone conclusion there will be any strategic transaction. The company could instead choose to conduct a large capital raise, merge a private competitor into the company, or even do nothing at all. For these reasons, Granite City is a pass for now.

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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GTT Communications, Inc. – GTT

Hello! I took a little break from blogging in order to move and also to onboard a sudden rush of new Alluvial clients. Now both tasks are mostly completed, and I’m back to talk about one of my favorite “growth” companies. Before I get into the specifics, let me take a little time to discuss what I mean when I say “growth” company.

Most investors want the companies they invest in to grow. They want management to roll out new and improved products and service offerings, tap into new customer markets, and generally increase company profits and cash flow on a per-share basis. This typically requires diverting a portion of operating cash flow to capital expenditures and R&D, and investors generally accept this, as long as it’s done judiciously.

What many investors dislike is when companies repeatedly raise external capital in order to fund acquisitions. There’s good reason for this. Many of these companies engage in acquisitions with no clear economic rationale, over-pay, then screw up the integration process. The end result is an enterprise worth the same or less, but with each shareholder’s stake diluted. So why does this happen? In my opinion, it’s because running a business and engaging in productive M&A activity are two different skillsets, and not every manager has both. Many successful executives who have done a great job building a business via organic growth start to believe they have the magic touch, and begin empire-building.

However, there are some management teams that excel at both day-to-day business operations and at making productive acquisitions, and their track record shows it. One of these management teams leads GTT Communications. GTT operates a global fiber network that offers bandwidth and connectivity to a host of major companies and government organizations. GTT uses its network to provide a variety of internet services that make it easier for its customers to access remote servers and work seamlessly between locations world-wide. I’d be lying if I claimed to understand every last service the company offers, but it’s clear that these services are in great demand and increasingly essential for modern commerce and governance. Just how important these services are can be seen in how GTT’s revenues and profits have grown. Take a look at the quarterly revenue and EBITDA history stretching back to 2007. I don’t expect any slowdown in the growth in demand for GTT’s services for years and years to come.

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It might not be quite clear from the graph, but GTT’s revenues grew from just $13.7 million in Q1 2007 to $49.2 million in Q3 2014. That’s a compounded quarterly growth rate of 4.4%. Annualized, it’s 18.7%. Along the way the company went from near break-even to substantially EBITDA positive.

The increasing demand for GTT’s services wasn’t responsible for the entire increase, though. You’ll notice a few sudden leaps in revenues from 2007 to now. GTT bought Colorado-based WBS Connect in late 2009 and Tinet in early 2013. Both of these acquisitions resulted in greatly increased revenues and improved margins, resulting from the company’s increased scale. Along the way the company also completed several other acquisitions, including nLayer and IDC Global. These acquisitions allowed GTT to broaden its service offerings and extend its reach globally.

Because these acquisitions required additional capital, GTT has repeatedly issued equity and taken on additional debt. Any time investors see a pattern of capital raises, they should ask “was it worth it?” After all, growth for growth’s sake is often detrimental. If returns from acquisitions do not cover the cost of the incremental capital required, shareholders’ investment is impaired. In GTT’s case, the answer is unequivocally “yes, it was worth it!” GTT’s strategy of raising capital to fund acquisitions has resulted in all-important scale. In other words, the increased asset and revenue base has allowed GTT to realize increasing EBITDA margins and returns on invested capital. The chart below illustrates GTT’s EBITDA margin and annualized EBITDA/Average Invested Capital from Q1 2007 to Q3 2014.

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GTT’s EBITDA margin shows a steady climb from below breakeven to the mid-teens. Meanwhile, return on invested capital now surpasses 30%, indicating increasing capital efficiency. These are very, very healthy trends for a growing company and they support increasing equity values. And sure enough, equity value has increased. GTT shares went for $1.28 five years ago today, and are up almost ten-fold since.

I have some theories as to why GTT’s acquisitions have been so successful, but before that, let’s talk about valuation. Readers will notice I’ve mentioned only EBITDA thus far, and not operating income or net income. There’s good reason for that, and it has to do with GTT’s business model. When GTT purchases another company, it records a large value for the acquiree’s intangible assets, like customer lists and relationships. These intangible assets produce large amortization deductions, even though little ongoing capital expenditure is required to maintain their worth. This is a big advantage at tax time! GTT’s amortization charges wipe out a large chunk of operating income. After interest charges, the result is negative taxable income, though the company’s free cash flow is positive. Here’s a look at GTT’s depreciation and amortization vs. capital expenditures over time, as well as free cash flow versus net income.

CaptureSince 2007, GTT has recorded total depreciation and amortization of $54.7 million while dedicating only $21.5 million to capital expenditures. Over the same period the company earned a statutory net loss of $82.2 million, while recording free cash flow of $38.5 million, ex-restructuring costs and net investment in working capital. (I am trying to estimate GTT’s “steady state” investment needs, hence the exclusion of growth-related expenses and working capital investment.)

Since September 30, GTT completed a few important transactions that change the reported financial figures. First, the company spent $40 million to acquire American Broadband. American Broadband reported $55 million in revenues for the trailing twelve months. Nothing regarding the company’s profitability was disclosed, but I’ll err on the conservative side, estimating an EBITDA margin of 15% and incremental annual EBITDA for GTT of $6 million from the acquisition. In order to fund the acquisition, GTT recently completed an equity offering of between 3.5-4.0 million shares, raising $42.0-$45.2 million. The exact number of shares sold has not yet been released, so I’ll use the mid-point of each figure. Using these assumptions, GTT’s valuation looks like this:

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That’s a lot of language and pro forma calculations to make a simple point. At the current market value, GTT offers a high single digit cash flow yield to the enterprise, even after accounting for capex. This wouldn’t be an unusual valuation, except for the fact that GTT’s organic revenue growth is nearly 10% and should remain so for many years to come. I am wary of valuing any company too generously, regardless of growth potential. Nonetheless, I think a yield of 5% would not be too aggressive, given GTT’s track record and prospects. That would equate to a share price of $18.99. A 6% yield would be $15.42.

Now, back to GTT’s deal-making prowess. What is it that has made the company such a successful acquirer? In my opinion, it’s nothing more than a highly incentivized management team with a long history of entrepreneurial success in the sector. Prior to the recent equity issuance, GTT’s management owned about 35% of the company, worth many times their collective annual compensation. GTT management’s personal fortunes are closely tied to the value of GTT stock. This gives them all the reason they need to avoid empire-building and careless use of shareholder capital, and instead remain laser-focused on completing only the transactions that will truly increase GTT’s value on a per-share basis.

Still, all the incentives and focus in the world are worth little if management simply lacks the talent for company-building through acquisitions. Fortunately, GTT’s leaders have strong pedigrees in the telecom industry. Between them, chairman/former CEO/largest shareholder H. Brian Thompson and current CEO Richard D. Calder, Jr. have spent time at MCI Communications, LCI International, Comsat International, Broadwing Communications and many other well-known telecom companies, all regular acquirers. I am confident that company leadership has a deep understanding of the markets that GTT serves and will continue to guide the company well.

In nearly every earnings report and transaction announcement, GTT’s management mentions a clear revenue and EBITDA target: $400 million in annual revenues and EBITDA of $100 million. That goal is still a ways off, but I suspect they’ll achieve it sooner of later and shareholders will do well along the way.

Alluvial Capital Management, LLC holds shares of GTT Communications, 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.

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Thanks for a Great Year!

Today’s post is a simple one, with just one purpose, to say thanks! to all the readers who have helped make 2014 a great year for OTC Adventures and for Alluvial Capital Management, LLC.

Just as in years past, your responses to my writings (praise and criticism alike) have provided invaluable insights and have helped make me a better investor. I am convinced that my readers are among the most experienced and astute value investors out there, and I am grateful for you sharing your wisdom with me. Side note: if you reached out to me this year and I failed to respond, I apologize! I get a lot of e-mail and despite my best efforts, occasionally I fail to respond in a timely manner. Please don’t hesitate to reach out again.

2015 promises to be an exciting year for me, both personally and in my blog and business efforts. In the next three months alone, I’ll be marrying my lovely fiancée and purchasing a home here in Pittsburgh (where your dollar still goes very, very far!). Your well wishes are appreciated for the many changes and challenges sure to follow. The OTC Adventures blog will continue with posts coming at a similar pace as I navigate the demands of my RIA business and personal life. As for Alluvial Capital Management, I am hopeful that 2015 will bring a unique set of value investing opportunities and another year of good performance for my clients.

I wish you all the best in your own endeavors in 2015, in investing, in your careers and in your relationships with friends and family. While professional and financial successes are worthy pursuits, let’s not forget to invest our time in those we love.

I’ll be back in 2015 with many more value investing ideas, focused as always on the small, the illiquid and the ill-understood. Until then, Happy New Year!

– Dave Waters, CFA

 

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BFC Financial/BBX Capital Part Two – Value in Complexity

Time for part two of my discussion of BFC Financial and BBX Capital, two related and complex companies. These companies possess significant value in the form of cash, loans, and real estate, shared ownership of a very valuable timeshare company, Bluegreen, and over one billion in NOLs. Due to the complicated ownership structure and a litigation overhang, the market has priced these companies at a massive discount to a conservative reckoning of their assets and earnings power.

Valuation

In part one, I estimated BBX Capital’s valuation at $631.6 million, or $39.46 per share. Valuing BFC Financial is actually a little easier. BFC’s value consists of some corporate cash, its 51% stake in BBX Capital, its 54% stake in Woodbridge/Bluegreen, and its NOLs. Since I already examined the value of BBX and Woodbridge/Bluegreen in the previous post, all that remains is to analyze BFC’s corporate cash and NOLs.

Due to consolidation, BFC’s balance sheet looks much more complex than BBX Capital’s.

BFC balance sheet

 

In truth, it’s not so bad. Most of the confusing entries belong to Woodbridge/Bluegreen or BBX Capital. Once those are removed, the picture becomes much clearer. For example, BFC’s balance sheet lists cash of $246.5 million. But of that, $160.2 million belongs to Woodbridge/Bluegreen, and $56.6 million belongs to BBX Capital/FAR, LLC. That leaves $29.7 million in cash at the BFC Financial level. (This excludes restricted cash, which I am ignoring for the purpose of this analysis.) Much of the remaining assets can also be ignored. All the various loans and real estate assets belong to BBX, and the notes receivable are associated with the Bluegreen timeshare business. Much of the property and equipment is as well, and the remainder is not material to BFC’s valuation. (Some of the property & equipment is attributable to some minor businesses the complex owns, which I am also ignoring for the scope of this analysis.)

The liabilities are much the same. The BB&T interest belongs to BBX’s FAR, LLC and the notes payable are Bluegreen’s, as are the junior subordinated debentures. (As discussed in the last post, $85 million worth of the debentures are Woodbridge obligations.) That leaves only the deferred taxes, share redemption liability, preferred stock and the ever-mysterious “other liabilities.” With the exception of the share redemption liability and the preferred stock, it’s somewhat unclear exactly what amount of “other liabilities” and deferred income taxes are obligations of BFC versus Woodbridge/Bluegreen or BBX. I don’t believe that BFC’s other liabilities require any ongoing cash flow to service or amortize, making them largely irrelevant to this valuation.

BFC possesses over $300 million NOL state and federal NOLs. However, around $80 million are limited by the company’s 2013 merger with Woodbridge. Estimating value of the NOLs is tough because BFC doesn’t reveal how much are state and how much are federal. For that reason, I’m ignoring their value entirely, even though they are certainly worth something. For the NOLs, I am including only 54% of those of Woodbridge and Bluegreen, which I value at $12 million using very conservative estimates.

All that’s left is to add up the values of BFC’s assets and liabilities.

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I estimate the value of BFC shares at $9.62. Just like with my BBX estimate, this value is intended to be conservative and could be markedly higher if Bluegreen is worth more than 8x pre-tax income, or the companies utilize their net operating losses well.

So why, if these companies really possess so much value, are they trading at 35%-40% of my estimates? It all comes back to one thing….

Litigation

The CEO of both BFC Financial and BBX Capital is Alan B. Levan. Mr. Levan is a colorful character, to put it lightly. As chief of BFC Financial and BBX, he’s pulled off a number of successful deals and transactions, but he’s also managed to anger many minority shareholders in businesses he has purchased. On more than one occasion, these shareholders have brought lawsuits.

In 2012, the SEC brought charges against Levan his actions during the financial crisis. The SEC alleged Levan and BankAtlantic had failed to write down loans in distress and had made misleading statements about the company’s financial standing to investors. As is typical for cases like this, the SEC and company attorneys battled in court for months and filings flew, but the case gradually crept forward.

In the meantime, Levan revealed plans to merge BBX and BFC Financial together, with BBX Capital shareholders receiving 5.39 shares of BFC for each share of BBX. Following the transaction, BFC would uplist to a major exchange. The benefits to shareholders would be  significant. No longer would investors have to look at two different companies to see the value of Bluegreen, and no longer would each company’s balance sheet show many confusing items and minority interests. With better visibility, clearer financials and an increased market cap, it’s not hard to imagine a new set of investors coming on board and pushing the share price upward.

With the planned merger in progress, the SEC’s case moved to trial. A summary of the SEC’s case and the counts against BBX and Levan can be found here. The trial took six weeks, but just last week the jury made its decision: guilty.

The monetary penalties won’t amount to much. The maximum civil penalty to BBX Capital for each charge is only $500,000. And there’s even a chance the decision will eventually be vacated. Previously, a judge reversed a jury’s finding on private litigation brought on roughly the same issues. The company’s statement in response to the guilty verdict is here.

Though the monetary cost of the guilty verdict is small, the harm to shareholders is large, for a few reasons. First, the planned merger between BFC and BBX is off for the time being. This means markets will continue to be presented with two complex and confusing entities, and will likely continue to undervalue them. Second, Levan and the companies will undertake an expensive and drawn out appeals process, which could result in years of legal fees and continued uncertainty. Levan seems to honestly believe himself above reproach in his conduct, and will fight hard to be allowed to continue to lead his companies.

So, investors in both BBX and BFC may have to exercise some patience. Their disappointment with the verdict and the merger cancellation are obvious by the share price movements, but the values of the company’s assets are unchanged and growing. The litigation will eventually be resolved (with or without Levan remaining at the helm) and the companies will be merged or otherwise resolved into one entity. Assuming leadership avoids any disastrous decisions and the economy in general avoids a financial crisis redux, patient shareholders should eventually realize an excellent return from today’s share prices.

Alluvial Capital Management, LLC holds shares of BBX Capital Corporation and BFC Financial 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.

 

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BFC Financial/BBX Capital Part One – Value in Complexity

Today’s post is the second in a series I’m informally titling “stocks that caused me grief in 2014.” The first in the series was Awilco Drilling. This post concerns BFC Financial and BBX Capital, two related companies that possess valuable assets worth multiples of their current stock prices. Not that you’d know it by the market’s assessment. As I type, BFC Financial is down 5% in 2014, but more tellingly down 36% from its 52 week high. BBX Capital is a similar sad story, down 22% in 2014 and off 46% from its 52 week high. This post will serve as an introduction and analysis of BBX Capital. I’ll tackle BFC Financial next time.

The reasons for the decline are many, but at the center is litigation, a canceled merger, and the complete inability of management to communicate the company’s value to investors or to use the companies’ massive cash balances productively.

Before I begin, a brief overview of the BFC/BBX corporate structure is needed. The structure is complex, and obfuscates the underlying asset value. Basically, BFC Financial owns 51% of BBX Capital. Together, BFC and BBX own 100% of a timeshare business: Bluegreen. BFC owns 54% of Bluegreen and BBX owns 46%. (Actually, Bluegreen is 100% owned by Woodbridge Holdings, LLC and BFC/BBX own 54%/46% stakes in Woodbridge. The distinction is mainly technical, though I feel I should point it out.) Here’s how it all looks:

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It may already be clear why the market has a difficult time assessing these companies. I’ll spend plenty of time talking about the value of each, but for today I’ll spotlight BBX Capital. When dealing with parent/subsidiary structures and financial statement consolidation, it’s always easiest to start at the bottom and work one’s way up.

BBX Capital Corporation

BBX’s value comes from three sources.

1. Cash, loans, and real estate.

2. Ownership in Bluegreen

3. Net operating loss carryforwards

Once again, a little background information is required. BBX Capital was once BankAtlantic Bancorp, which owned BankAtlantic, a Florida bank. BankAtlantic got into serious trouble with bad loans, and was eventually sold to BB&T Bank. The remaining holding company then renamed itself BBX Capital. As part of the deal to sell BankAtlantic, BBX Capital and BB&T created an entity named FAR, LLC (Florida Asset Resolution Group, LLC) to hold and resolve many of the bad loans and real estate that BankAtlantic had once owned. This was the classic “bad bank” structure. As part of the deal, BB&T owned a 95% preferred claim to FAR’s assets with a face amount of $285 million. In simple terms, as FAR sold off foreclosed real estate and resolved bad loans, BB&T was entitled to 95% of the distributions until it had received $285 million. It was also entitled to interest on the unredeemed preferred interest. Once BB&T had received its $285 million with interest, BBX would receive all the remaining cash flows from asset resolutions.

FAR turned out to be immensely successful for BBX Capital. As of September 30, 2014, BB&T’s preferred claim had been reduced to just $14.17 million and FAR’s net worth was substantially positive. Now that BB&T’s preferred interest has nearly been eliminated, it’s very easy to ascertain BBX’s cash, real estate, and loan assets. The chart below shows these assets for the holding company and for FAR, as well as some other minor tangible assets that BBX Capital owns.

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Net of all liabilities, BBX Capital owns $222.1 million cash, real estate, loans, and other minor tangible assets. About one-third of the total resides within FAR and will become fully available to BBX once BB&T’s remaining $14.17 million interest is eliminated. Note that this $222.1 million value is conservative. Much of the real estate on BBX’s books is listed at historical values well below current values, which have recovered quite a bit since the financial crisis.

That brings us to Bluegreen, which represents the greatest portion of BBX Capital’s equity value. Bluegreen is in the business of timeshare sales. Timeshares don’t have the greatest reputation to say the least. The industry has earned a reputation for aggressive sales tactics and poor underwriting. But there is still a demand for timeshares, and lending standards have tightened up considerably since the crisis. Bluegreen is not the same “sub-prime” business it once was.

Assigning a value to Bluegreen is not as straightforward since Bluegreen is an operating business. If you’re wondering where Bluegreen shows up on BBX’s balance sheet, it’s as an equity investment in Woodbridge Holdings, LLC. The value is listed at $77.2 million as of September 30, 2014. That’s a ludicrous valuation, and it’s simply an artifact of GAAP accounting. Bluegreen produces nearly $100 million in pre-tax income, and throws off substantial cash. In the last twelve months, Bluegreen dividended $61.5 million to Woodbridge. BBX’s share is $28.3 million. Bluegreen also holds $159.6 million in cash, indicating quite a bit of excess capital. Even if it requires 10% of revenues in operating cash, Bluegreen has $108.6 million in excess cash. Clearly, Bluegreen is worth many times its balance sheet value to BBX.  Here’s a look at Bluegreen’s historical results, its excess cash, and a valuation range.

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At a reasonable multiple of 8x pre-tax income, Bluegreen’s value to BBX Capital is $411.3 million. There’s one additional wrinkle: Woodbridge, Bluegreen’s immediate owner, has issued $85 million in junior subordinated debentures. BBX’s 46% share of this liability, $39.1 million, brings my estimate of Bluegreen’s value contribution down to $372.2 million.

That brings me to BBX’s third source of value: its net operating losses. These are substantial. Between its own NOLs and those at Bluegreen, BBX possesses hundreds of millions in loss carryforwards, none of which expire any time soon. The graphic below summarizes these NOLs as of December 31, 2013.

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Evaluating the worth of NOLs is difficult, especially in a case like BBX Capital where there are multiple entities involved. To be conservative, I’ll simply take the cash value of the NOLS (tax rate * NOL) and discount that by two-thirds. With federal/other corporate tax rates at 35% and Florida’s corporate tax rate at 5.5%, I get a net value of $37.3 million. Again, that’s extremely conservative. It’s possible that BBX will realize a much greater portion of these NOLs and much earlier by selling off real estate or monetizing its interest in Bluegreen.

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So there we have it, the three components of BBX’s equity value. Combined, I estimate their value at $631.6 million, or $39.46 per share. This value could be quite a bit higher depending on the appreciation in BBX’s real estate portfolio, NOL usage and the ultimate valuation of Bluegreen. BBX also has some other minor assets that could contribute a small amount of equity value.

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I realize how it sounds when I casually posit a value per share more than 200% higher than the most recent trade. But if anything, I think BFC Financial is even more under-valued. More on that in my next post.

 

Alluvial Capital Management, LLC holds shares of BBX Capital Corporation and BFC Financial 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.

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Value Investing at the Frontiers

Slight change of pace from my usual postings today. Regular readers are well-aware of my investing focus: the smallest, least-analyzed companies, often churning out profits in unglamorous industries. Many times the stocks of these companies are difficult to buy in size, and sometimes even finding financial information is a challenge. My reasoning for targeting my efforts in this arena is pretty simple: why compete with more investors than I need to? The data on the results investing in tiny, illiquid stocks are compelling (a decent white paper can be found here), and I expect that to continue. This style of investing is not a panacea. There are issues with scalability, and the returns are anything but stable. But I believe most serious investors are well-served by dedicating a portion of the capital to micro-cap and thinly-traded securities strategies.

I’ve been richly rewarded by many of the opportunities I’ve managed to locate at the bottom end of the market’s size and liquidity spectrum, both in the US and abroad. (And punished by some others, but the balance remains quite positive.) Digging through the thousands of securities available for trading in the US alone is endlessly entertaining. But like most value investors, I’m always hungry for new opportunities. Sometimes that means expanding one’s reach to new markets.

A basic tenet of my investing philosophy is that structural barriers always create inefficiency. Basically, any market that some investors cannot access without great difficulty will have an unusual number of inefficiently-priced securities. That brings me to a topic that’s been on the forefront of my mind recently: finding investments in “exotic” markets, and/or on “exotic” exchanges. It’s only in the past few years that most major world markets have become relatively accessible to US investors. ADRs have been around for quite some time, but now I can purchase stocks directly in Western Europe, Australia, Mexico, Japan, Hong Kong and several other large economies with relative ease. It’s a very positive development and it has greatly expanded the opportunity set for value investors willing to cast a wide net. But even this expanded access still leaves a very large set of the world’s equities beyond the easy reach of Western investors.

In my searching, I’ve already come across several stock markets that are difficult for American investors to access, but not impossible. Fidelity or Interactive Brokers won’t get you in, but working with a local broker can. Sure it’s a hassle, but that’s what creates the opportunity. Some of these markets are hardly recognizable as a modern stock exchange. I recently found a national stock market where that particular day’s total trading volume was…..zero shares. Zero shares, with over 20 listed companies! I talk to some investors who can’t believe I buy stuff with under $100,000 in daily liquidity, so I’d like to see those same investors react to a market like that!

And some of the markets I’ve happened across offer incredible values. I recently checked out the stock market of a small yet well-known nation with 30-some listed companies, and was astounded by the valuations on offer. Median P/E ratio: 6.1. Median price/book value: 0.58. Average yield of dividend paying companies: 6.3%. Average ROE: a respectable 9.8%. This nation is not as stable or developed as most Western economies, but neither is it some warlord-run kleptocracy that would justify these absurd figures.

I’ve only just begun my search, but I strongly suspect there are many more stock markets like this one. And so for perhaps the first time (and sorely over-due) I’m asking my readers for advice. I’m asking you to relate your own experiences of purchasing stocks in obscure locations and exchanges. I’d prefer e-mails to comments, unless you don’t mind sharing your thoughts with the general public. In return, I’ll gladly tell you all about this particular cheap market I’ve found. Specifically, I want to know a few things.

  • How did you discover your unusual market(s)?
  • What kinds of hoops did you have to jump through to gain access? How did you choose a local broker? Were there any cross-cultural/regulatory challenges you had to navigate in the process?
  • What was your investment approach? Did you buy a basket of cheap stocks, or concentrate your efforts?
  • Stories of success or failure?

I’m also open to hearing about opportunities you’ve found in unconventional exchanges/brokerages in your own country of residence. Things such as FNC Ag Stock, LLC, which facilitates trading in agricultural partnerships.

I look forward to hearing from you. Perhaps I’ll relate a few of the more interesting anecdotes I receive (with permission, of course) in a future post.

OTCAdventures.com is an Alluvial Capital Management, LLC publication. Alluvial clients may hold positions in any stocks mentioned.

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What’s Up With Awilco Drilling?

Post edited after a helpful reader pointed out some calculation errors. The conclusions reached have not changed. That’s what I get for writing after midnight.

I’ve haven’t written on Awilco Drilling for a while, but the company’s never been far from my mind. How could it be, when the past five months have been one long, painful slide from over $26 to $11 per US ADR? The reason for the decline is obvious: an unforeseen and extraordinary decline in oil prices and the associated carnage in nearly all oil-related companies. In hindsight, there were obvious signs of coming weakness that I ignored. Chief among them was the large share sale by the company’s controlling shareholders. At the time I dismissed it as merely portfolio reshuffling and profit-taking. The sting of loss has a way of clarifying reality, and it now seems obvious that the Wilhelmsens knew exactly what was ahead for the sector and reduced their exposure accordingly.

The past is the past and it can’t be changed, but now the question in every suffering investor’s mind is: what does the future hold for Awilco shares?

First, let’s take a look at just how severe Awilco’s decline has been relative to its peers. The graphic below shows the change in Awilco’s enterprise value and market capitalization since its shares peaked on July 24. Figures are presented in local currency millions. Net debt is reduced for the balance sheet value of newbuild assets. Note this analysis does not attempt to incorporate changes in the market values of rig operator debt, which has undoubtedly decreased.

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Of the various offshore drilling companies on the list, Awilco’s enterprise value has declined the most since late July. On one hand, Awilco had been one of the best performers in the segment in the months leading up to the collapse. On the other, Awilco’s low leverage and robust backlog make the magnitude of the decline difficult to understand. Awilco doesn’t compete in the ultra-deep-water space, where over-supply and reduced investment will take the greatest toll. Nor should investors worry about liquidity because Awilco has no funding commitments for newbuilds and its debt isn’t due until 2019.

My theory is that Awilco’s share have been punished by an exodus of yield-chasing investors concerned with the sustainability of Awilco’s dividends. Their fears are justified, to an extent. The near-certain decrease in dayrates will crimp Awilco’s dividends once the current contracts are completed. But Awilco’s current valuation seems to anticipate a near-complete elimination of earnings/dividends once WilPhoenix’s contract with Apache is up in mid-2017.

The chart below projects Awilco’s contractually guaranteed earnings for the next eleven quarters, from now until the company’s final rig contract expires. These projections include a number of assumptions, laid out below.

1. WilHunter ceases operations in December 2015 and is not active for the duration of the projection.

2. WilPhoenix is inactive from mid-April 2016 to mid-June 2016 for yard time.

3. Yard survey expenses for each rig are $15 million.

4. Daily rig operating expenses are $92,000.

5. Quarterly interest expense begins at $2.19 per quarter and is adjusted for bi-annual $5 million principal amortization.

6. Depreciation is $4.5 million per quarter, increasing by $0.625 million once each blow-out preventer is installed.

7. The tax rate is 20%.

That’s plenty of assumptions. Here’s my projection:

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Between now and mid-2017, Awilco should earn about $205 million. Peak earnings will be Q1-Q3 2015, when both rigs are in full operation. The worst will be Q2 2016, when WilPhoenix is idled for most of the quarter. Of course, reality will differ from this projection. But the most important takeaway is just how much of Awilco’s market capitalization is represented by earnings that will arrive within three years. Over 60%! Fully 46% of Awilco’s current $333.6 million market cap will be earned between now and the end of 2015.

The market seems to be awarding only nominal value to Awilco’s potential earnings once its current contracts expire. To put this in perspective, the remaining metal fatigue lifespan of each rig (per the company) is around 15 years. Now, I don’t expect each rig to be employed for the full 15 years if dayrates experience a significant decline. But I do expect each rig to be employed in some fashion for at least a decade, and to have some residual value at the end of that term, if only for scrap.

Assume for a moment that each rig is employed for another ten years. Backing out the current contracts leaves 16.5 rig-years remaining until each rig is sold or scrapped. Subtracting the contractually guaranteed earnings of $204.8 million from Awilco’s current market cap leaves only $128.8 million, or just an undiscounted $7.8 million per year, per rig. Barring an outright collapse of the oil economy, I have difficulty seeing any sort of scenario in which Awilco’s earnings power declines 90% in the coming years. (Doesn’t mean there’s no way it could happen, only that I think it’s extremely unlikely.)

To reinforce the point, let’s take a look at a scenario in which dayrates for Awilco’s rigs decline by nearly 50% to $200,000 per day. The graphic below lays out yearly earnings and cash flows for this scenario. It assumes daily rig operating expenses decline 20% once the current contracts expire, which I think is reasonable for a scenario in which rig-workers and suppliers suddenly find their services much less in demand. This projection, like the one before it, includes a lot of highly uncertain projections, like another two-month yard stay for each rig in 2020/2021, selling off the rigs for half of book value in 2024, and the release of all net non-cash working capital in the same year. It includes $25 million special capital expenditures for each rig for upgraded blow-out preventers, which are then depreciated over a ten-year schedule.

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Using these assumptions, the present value of Awilco’s future cash flows is $356.2 million, or $11.86 per share. At the current price of $11.11 per US ADR, it seems the market is expecting a scenario worse than this: one in which dayrates decline even more, or Awilco’s rigs have shorter lifespans, or where one or both rigs is off-lease for substantial amounts of time.

Is that possible? Definitely. But it’s also possible that dayrates don’t decline by half, and in that case, Awilco is worth a lot, lot more than its current price. (At dayrates of $250,000 and daily rig operating expenses of $78,200, my estimate of present value rises to $15.87 per US ADR. The value only goes up from there if the rigs operate for longer than 10 years.)

If anything short of a complete collapse in offshore drilling dayrates is ahead of us, Awilco Drilling is likely a good buy at these levels. If a complete collapse arrives, Awilco will still reap about 61% of its market cap in its earnings over the next 11 quarters, which should provide some downside protection.

The next big test for Awilco will be if it can re-lease its WilHunter rig to Apache for 2016, or failing that, lease the rig to another operator for a reasonable time period at a dayrate remotely similar to what it earns now. If they are successful, I expect the stock to experience quite the relief rally. If not, the stock could find itself languishing at these levels for a while. Apache and Awilco must agree on terms for 2016 by late February, or Apache’s option will expire.

Given Awilco’s strong management team and clean balance sheet, I expect them to find a solution for WilHunter. Awilco’s value has been reduced by the rapidly deteriorating oil market, but I view the stock’s decline as too far, too fast. I made a mistake by not selling Awilco high. I don’t intend to compound my mistake by selling low.

Edit: In writing this piece, I wasted far too many words trying to say something simple. Suffice to say, Awilco’s current enterprise value is equal to contractual earnings from now until mid-2017, less yard expenses, plus net receivables and inventory, plus  54% of rig book value (including the new blow-out preventers.) If Awilco’s rigs are worth more than 54% of book value, it’s very likely that Awilco is under-valued. My opinion is pretty clear.

Alluvial Capital Managment, LLC holds shares of Awilco Drilling Plc 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.

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JPS Industries – JPST

JPS Industries produces advanced fibers for use in a wide variety of applications, like aerospace, insulation, electronics, construction, body armor and many other product types. JPS struggled for years with excess leverage and unfocused operations, but now has shed all its debt and slimmed down to a single division. The company’s largest shareholder controls the board and is focused on reducing costs and driving profitability.

JPS’ corporate history can be traced all the way back to 1813, when it was founded as J.P. Stevens & Co., a South Carolina textile producer. The company expanded into many different business lines in the 20th century before being taken over by private equity in the leveraged buyout boom of the 1980s. Bankruptcy followed in 1991, and again in 1997. Today’s incarnation of JPS Industries arose from the 1997 bankruptcy restructuring. JPS is now just a small shadow of its former size and significance, with most of its assets long since sold off to other companies.

Despite multiple trips to bankruptcy court in the 90s, it seems that JPS had not quite learned its lesson. In 2007, the company used debt to finance a $62.5 million buyout of Hexcel’s fiberglass and industrial substrate business. At the time, JPS CEO Michael Fulbright was quoted saying “…we anticipate that the new JPS Industries will
have annual sales in excess of $325 million…” The reality was much less rosy. The financial crisis hit hard and JPS’ 2008 revenue reached only $232.5 million, nearly 30% below target. The new debt, combined with a ballooning pension deficit caused by the stock market crash, wiped out JPS’ profitability for years to come.

JPS spent the next several years in recovery mode, using cash flow to reduce debt and selling off its Stevens Roofing division. The company’s recovery process was slowed by a litigation loss of over $10 million in 2011, the result of a long-running dispute over intellectual property.

The next few years saw the hedge fund Steel Partners begin to target JPS, ultimately buying up nearly 40% of the company’s shares. At various points, Steel Partners offered to buy the company outright, though it was ultimately rebuffed. In 2013, Steel Partners won a proxy contest and installed four directors on JPS’ board. Steel Partners then installed Mikel H. Williams as CEO.

Almost exactly one year to the day after the company leadership change, JPS Industries announced an agreement to sell its Massachusetts-based Stevens Urethane business to Argotec. The price of the sale was not disclosed, but it was sufficient to eliminate all of JPS’ debt . JPS’ net leverage including the pension deficit decreased from $56.8 million on February 1, 2014, to $30.3 million on May 1, suggesting a selling price of around $26.5 million for Stevens Urethane.

JPS’ remaining JPS Composites division is having a good year, with revenues for the first three quarters of 2014 up 7.8% from 2013. Adjusted for one-time severance charges related to the CEO change and a litigation recovery, operating income is up 10.9%. Though gross margins were compressed, good cost control resulted in increased operating margins.

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Since Steel Partners’ representatives took control, JPS’ cost control efforts have been successful. Operating expenses for the first nine months of fiscal 2014 were down slightly even as sales rose.

JPS’ trailing results are difficult to compute due to the Stevens Urethane sale. However, the company appears reasonably priced based on annualized 9 months figures.

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At this point, some discussion of JPS’ pension liability is warranted. Though much smaller than at any time in recent years, the size of the liability is still a potential source of trouble for the company. At the end of fiscal 2013, the pension assets were allocated aggressively, with 71% invested in equities. Interestingly, 28% of pension assets are invested in company stock, valued at $11.70 per share by an outside consultant. This “self-investment” introduces an element of pro-cyclicality. Should JPS’ operations perform well and the stock’s value increase, the pension deficit will decrease, perhaps spurring additional stock gains. This would reduce the pension deficit further, creating a virtuous cycle. On the other hand, if operations go south, the pension deficit could widen as JPS stock value decreases. This would require additional pension contributions, a textbook vicious cycle.

Though JPS’ pension plan is aggressively allocated and holds a substantial investment in its own stock, management’s stated intent is to continue to reduce the deficit through cash contributions. This is somewhat comforting to me as a potential investor, but for now the company’s exposure to pension risk remains high. Though pension liabilities don’t carry the refinancing risk that term debt does, they carry real cash requirements that must be incorporated in any estimate of a company’s value.

JPS appears to have momentum behind its operational improvements, and I believe its valuation will compress quickly once cost savings kick in fully and the pension deficit is reduced. Perhaps most importantly, I believe JPS Industries will benefit from Steel Partners’ control. Former management was engaged in debt-fueled empire-building, but the new management team appears focused on operational efficiency and cleaning up JPS’ balance sheet. Steel Partners may look to make an exit at some point via a sale of the company to a competitor, and an efficient company with an adequately funded pension is much more easily marketed.

JPS also possesses substantial net operating losses, though these are limited by an ownership change that took place years before. Still, the company is able to shield some earnings from taxation, which should raise its valuation modestly.

Alluvial Capital Management, LLC does not hold shares of JPS Industries  for client accounts.

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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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