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.

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 Swiss Bargain: Bergbahnen Engelberg-Truebsee-Titlis AG

Just a brief business update before I get going on today’s company profile. Things are good at Alluvial Capital Management, LLC. Assets under management will soon reach $6 million, and performance since inception has been solid. Thanks again to the many blog readers who have become clients. New clients are always welcome! I’ve revamped my firm’s website a bit, if anyone would like to check it out. For a guy with zero experience with design, I don’t think it looks half bad.

My readers ask me how I discover the stocks I write about. There’s no single answer, and in fact I find many by reading other blogs, online forums, and Twitter. But the majority I stumble upon through simple screening and follow-up research. I start with a particular geography or industry and go through the small companies I find one by one. I’m not mechanical about it; if I find a particularly interesting company or an unusual investing theme comes to mind, I’ll follow that path to see where it goes. For example, this week I decided to generate a list of Swiss companies with high share prices. Switzerland is full of very old companies and many have multiple business lines, which often leads to disguised assets. Additionally, many micro-cap companies with high share prices are inefficiently priced due to miniscule trading volumes. Anyway, one of the first companies I happened across was BVZ Holding AG, which operates a railway that provides the only access to Zermatt, a Swiss resort community in the Alps. Immediately, I thought of another Alpine railway company and a favorite investment of mine, Jungfraubahn Holding AG. My reasoning remains simple: companies like these are virtually immune to competition because of the astonishing cost (financial, environmental, and aesthetic) that creating additional railways in the pristine mountains would require. BVZ appears cheap at just 9x earnings and half of book value. But as I continued my analysis, I discovered some serious drawbacks. Chiefly, the company has low margins, low returns on capital and extremely high leverage. Returns on assets and equity languish in the low single digits and net debt is 6.6x EBITDA. Try as I might, I can find no convincing reason why these factors might change, so BVZ Holding was out. I was sad to see an interesting company turn out to be unattractive, but I then found myself wondering if there were any other Swiss Alps railroad operators I’d yet to examine. Sure enough, there are a handful! And the best of these is quite a mouthful: Bergbahnen Engelberg-Truebsee-Titlis AG.

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BETT,” as I’ll call it, operates a railway that carries recreationers up the Titlis Mountain in central Switzerland, as well as gondolas and cable cars between the various slopes and lodging areas. Among many other attractions including hotels and restaurants, the company operates the spectacular Glacier Cave and the Titlis Cliff Walk, Europe’s highest suspension bridge. In 2013, transport made up two-thirds of revenues, while hotels, restaurants and other accommodations made up the rest. It’s a straightforward business model, and it’s a profitable one. BETT’s revenues have grown at an annual pace averaging 4.5% over the last twenty years, while operating income growth has averaged 10.4%. The effect of such superior long-term growth is impressive:  from 1993 to 2013, the company’s operating income rose  600%.   Today, BETT is earning better EBITDA and EBIT margins than ever before. For the twelve trailing months, the EBITDA margin reached an exceptional 47.2%, while operating margins reached 36.6%. Here’s a look at the company’s results for the last few years expressed in Swiss Francs.

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Doubling operating margins and quadrupling earnings since 2007 is no small feat, and investors should examine how this was accomplished. The main driver behind the increase has been increasing visitorship. Per the company, recent years have seen an influx of new visitors from Asia. Switzerland has become a very fashionable place for a vacation among newly wealthy citizens of China and other rapidly growing Asian nations. Revenue growth in excess of operating cost growth creates operating leverage, resulting in rapid earnings growth. BETT has also been a smart investor in its own growth. The company has used its consistently strong cash flow to upgrade and expand facilities, further increasing its capacity and attractiveness as a destination.

Sharp-eyed investors may notice an earnings anomaly in 2010, where net income declined  75% despite a sharp increase in EBIT. That year, the company suffered an unfortunate setback when over 10 million CHF in Asian market investments made by a company executive turned out to be wholly fraudulent. Naturally, the executive was fired and prosecuted, but the funds were essentially gone. Following the fraud discovery, BETT made big reforms to its corporate governance designed to prevent future losses.

One might think that a recreation business sporting operating margins in the mid-30s would quickly attract competitors, yet it doesn’t appear to be so for BETT. The uniquely challenging geography of the Swiss Alps, as well as a strong desire on the part of the local government and populace to conserve the region’s beauty severely limits competitors’ ability to construct competing hotels or transportation routes. (Compare this to what happens in locations without such limitations. The American Niagara Falls, anyone?) Because of this limited competition, I expect BETT to continue to earn above-average margins nearly indefinitely, or for at least as long as the winter sports and vistas of the Swiss Alps remain popular.

For such a unique asset with a strong history of high returns and growth, one might expect to pay a premium price. Turns out that’s far from the truth. BETT shares can be had for just 7.2x EBIT or 7.5x earnings. Net debt is very reasonable at less than trailing operating income.

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Just try buying a similar-quality asset virtually anywhere in the world for 7x operating income.

I believe the primary cause of BETT’s low valuation is its liquidity. The company’s free float is only about CHF 137 million, uninvestable for many large funds. And daily trailing volume averages only about CHF 50,000, making building a large position quite the challenge for those same funds and institutions. But perhaps not for you!

The other significant factor that may influence BETT’s valuation is its increased reliance on tourists from Asia. Should the Chinese economy experience a sharp downturn, the ability of wealthy Chinese to afford expensive Swiss vacations will be curtailed. In that event, BETT’s operating margins would drop. While any Chinese slowdown would have a harmful short-term effect, I think the long-term outlook for BETT is positive as Asian consumers continue to grow in number and in wealth.

Alluvial Capital Managment, LLC does not hold shares of Bergbahnen Engelberg-Truebsee-Titlis AG for client accounts. Alluvial does hold shares of Jungfraubahn Holding 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.

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Retail Holdings Tries Investor Patience, But Value Continues To Grow – RHDGF

I don’t spend much time revisiting companies I’ve previously written up for this blog, but now and then it’s fun to check in and see how the a business has progressed, as well as its stock’s performance. One company I’ve written on a few times is Retail Holdings NV. For anyone not familiar with the company, Retail Holdings owns stakes in various consumer durables companies in Southeast Asia, all of them doing business under the historic “Singer” brand name. When I first wrote about the company in 2012, Retail Holdings traded at a large discount to the value of its publicly-traded subsidiaries.

Fast-forward to today, and the company still trades at a large discount to the value of its publicly-traded subsidiaries. In fact, the discount has grown, due to the increasing value of those subsidiaries. Retail Holdings own stock has been frustratingly, tryingly lethargic. ReHo’s stock price at the time of my original article nearly two years ago was $22.75. Today? It’s $18.05. Even with the two $1.00 dividends in the interim, Retail Holdings’ shareholders have suffered losses while the market is up 40%+.

So what gives? ReHo’s underlying businesses have actually performed well, so that’s not the issue. Consolidated revenues hit a new record high of $458 million for the twelve months ended June 30, 2014, and adjusted operating profits rose 22% since the same period two years ago. And it’s not as if the market values of the company’s subsidiaries have fallen. In fact, the company’s Indian and Bangladeshi holdings have appreciated substantially in 2014.

I suspect that Retail Holdings’ performance is mainly due to two factors. The first and more serious factor is investor distrust. In June 2013, Retail Holdings announced it would pursue an IPO of its Asian holdings. Great news! The market would finally show the stock some respect once a large part of those stockholdings were converted to cash! But alas, it’s wasn’t to be. Several months later,  company scuttled the IPO process citing poor market conditions. Heartbreak. I can’t blame the company entirely. The market really did turn sour as investors grew nervous about the India’s economic stability. But the damage was done, and now the company suffers from a credibility deficit. Investors will be much less likely to trust Retail Holdings when the IPO process is eventually re-started. Second, investors woke up the reality of doing business in developing economies. And Retail Holdings operates in some of the most “developing.” Pakistan’s issues are well-known, and Sri Lanka only recently put a 30-year civil war to rest. Even Thailand, tourist hotspot that it is, was wracked by protests and work stoppages this year. Together, these nations account for almost half of ReHo’s asset value. Retail Holdings’ largest asset by market value, Singer Bangladesh, also suffered the effects of instability. Singer stores in Bangladesh were shut down for over two months in 2013 by strikes.

When I first wrote about Retail Holdings back in 2012, I pegged net asset value per share at around $27. NAV per share has risen at a healthy rate since on the strength of rising revenues and earnings. Precise market cap figures for some of ReHo’s subsidiaries are tough to track down, but today’s NAV breakdown looks much like this:

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In addition to its corporate subsidiaries, Retail Holdings also owns some securities, notes it was issued during its reorganization a decade ago. These can be generally described as “distressed” and have undergone multiple restructurings. The par value of these notes is $23.8 million, or about $4.50 per share. However, I think a haircut is warranted due to the non-marketability and dubious credit quality of the notes. Assuming a 30% discount yields per share value of $3.15.

Retail Holdings also holds some corporate-level cash, though the exact amount is uncertain and is probably low following the recent dividend. I’ll ignore it. The combined per share value of the public subsidies and notes is $34.81 by my estimate, a 93% premium to today’s closing price for Retail Holdings’ shares of $18.05. Put differently, ReHo shares are trading at a discount to NAV of at least 48%.

So what will it take for Retail Holdings shares to finally reach their intrinsic value? Probably an IPO of the company’s Asian assets, though who knows when that will take place. In the meantime, I am content to wait, so long as the intrinsic value of the company’s Asian subsidiaries continues to rise. This seems likely, as all the various operating subsidiaries have showed healthy gains in revenues and income over the past several years and occupy a strong market position in their economies. It will be a happy day when Retail Holdings officially completes an IPO or goes private, even if we investors must wait awhile longer.

 

Alluvial Capital Managment, LLC holds shares of Retail Holdings 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.

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Rand Worldwide, Inc. – RWWI

It’s good to be back! I hope readers will excuse my weeks-long radio silence. A full travel itinerary took me to Chicago, Savannah, and elsewhere for business purposes and otherwise. During this stretch I also found the time to participate in a webinar, talking about strategies I use to identify attractive companies. A replay can be found here. My segment starts about an hour into the recording, though sadly the audio recording and the Powerpoint slides I used seem to be badly out-of-sync.

Today’s value idea is a company I came across only recently, and one I own in size for Alluvial Capital Management, LLC clients. It has practically everything I like to see in a micro-cap stock: healthy top-line growth, expanding margins, excellent free cash flow, capable and shareholder-oriented management and best of all, a very modest valuation.

Rand Worldwide, Inc. is a value-added software reseller. Design and engineering companies use complicated and expensive software suites from companies like Autodesk, Dassault Systemes, and Autonomy. However, these software packages are not exactly effective if employees are not properly trained in their use, or if the software won’t integrate with other software systems, often older or proprietary. This is where Rand Worldwide steps in, providing training and software management services that help companies maximize their software investments. Rand’s relationship with Autodesk is especially important, with Autodesk products accounting for 95% of Rand’s software resale revenues.

Rand’s recent results have been strong, with total revenues rising 11.0% in fiscal 2014 to a record $91.6 million. This revenue growth is being buoyed by chief software supplier Autodesk’s own strong results. After years of moribund revenues, Autodesk returned to growth with sales rising 3.9% year-over-year for the twelve trailing months completed July 31, 2014. More recent results have been even better, with revenues rising 8.6% for the quarter ended July 31, 2014 versus the same quarter one year ago. For the fiscal year ending January 31, 2015, Autodesk is guiding for revenue growth of 7-9%. These results are worth watching, because Rand’s own revenues appear to track closely with the rising and falling fortunes of Autodesk.

Rising revenues and good cost control creates positive operating leverage. Rand’s results are the perfect example. The year’s 11.0% revenue increased resulted in a 59.6% increase in operating income and a 42.8% increase in EBITDA as the company was able to spread stable fixed costs over a larger gross profit base. Operating margins, adjusted for a one-time goodwill write down and contingent consideration change, rose to 8.2% from 5.7% the previous year. Looking below the operating income line, the company’s minimal interest expenses and net tax benefit allowed it to report a large net income figure for the year just ended.

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In Rand Worldwide, we have a company experiencing healthy grow and record revenues, which is leading to margin expansion and large earnings increases. A nice scenario. However, that’s just the start. Since the end of the fiscal year, Rand has taken multiple steps to increase its market value. First, the company has sold off a loss-making division, Rand Secure Data. The sales proceeds were minimal, but by selling the division Rand disposed of a major headwind. In 2014 alone, Rand Secure Data was responsible for an operating loss of $2.6 million. Rand’s trailing operating income ex-Secure Data would have been 34.1% higher.

Second, Rand Worldwide is in the midst of completing a huge share tender funded via a debt issuance. In the tender offer, Rand Worldwide will repurchase 27.5 million shares, equal to 50.5% of basic shares outstanding. The tender price is $1.20 per share and will cost the company $33.0 million. The cash outlay will be funded from cash on hand, plus a term loan of $25 million. Rand will also enter into a revolving line of credit sufficient to support business operations.

A leveraged recapitalization makes abundant sense for a company like Rand Worldwide. The company generates a ton of cash and has minimal investment requirements. Prior to the recap, the company used practically no leverage, so replacing a large chunk of the capital structure with cheap debt should reduce its cost of capital significantly. From a sheerly mathematical perspective, the figures are incredibly compelling. Per its press release dated September 29, Rand earned 16 cents per diluted share from continuing operations. At a repurchase price of $1.20, rand is buying its own shares at an earnings yield of 13.3%, compared with a cost of debt that will likely fall in the mid single-digits or lower.

Rand has released pro forma financial statements for the recently completed fiscal year as if both the Secure Data sale and the tender offer had been completed at the very beginning of the fiscal year.

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In additional to the company’s own projections, I’ve gone ahead and provided net income estimates at normalized tax rates. On a trailing basis, the Secure Data divestiture and tender offer/recap would have had a major impact on normalized earnings per share.

As I write, Rand shares last traded at $1.29, with a market cap (pro forma for the tender offer) of $38.1 million, fully diluted. The company is extremely cheap on both an absolute basis and in comparison to similar technological services companies.

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I always like paying mid single-digit multiples for healthy and growing businesses, but Rand has another factor that sweetens the deal: highly competent and incentivized owners. Once the tender offer is completed, Rand’s majority owner will be Peter Kamin, by way of his 3K Partnership. I have long admired Mr. Kamin and his track record (in general and with micro-cap stocks) is to be admired. Peter Kamin was a founding partner at the extraordinarily successful ValueAct Capital, and left to found his own firm in 2011. Long-time readers of this blog may recognize Mr. Kamin’s name from his involvement in Calloway’s Nursery and Rockford Corp.

In connection with Mr. Kamin’s takeover, he will also install his own choice for CEO (the company’s current CFO, Lawrence Rychlak.)

Examining another of Mr. Kamin’s ventures may shed some light on a potential future course for Rand Worldwide. Peter Kamin is a large shareholder and director of MAM Software Group, Inc. a company that sells enterprise software to the automotive after-market industry. This software provides function like inventory and store management for tire distributors and other similar businesses. Rand Worldwide and MAM Software Group are not identical; Rand mainly sources its software elsewhere while MAM develops and sells its own. However, the two businesses are like enough that similar strategies apply to managing and growing each company.

When Mr. Kamin joined MAM Software as a director in May, 2012, MAM traded over-the-counter at a price of just over $2.00. Trailing revenues were $25.7 million and trailing EBIT was $3.9 million. MAM’s enterprise value was $26.9 million for an EV/Revenue multiple of 1.0 and an EV/EBIT multiple of 6.8. Fast-forward to the present. Since May of 2012, MAM uplisted to the NASDAQ and grew its trailing revenues by 19.3% to $30.7 million. Operating profits are actually down on higher R&D and marketing expenses, which the company characterizes as investments in the company’s future. But the company’s share price? Up 128%. MAM now trades at an EV/Revenue multiple of 1.9.

That’s the power of moving from the obscurity and neglect of the OTC markets to the spotlight of the a major exchange. MAM’s business certainly grew, but the price appreciation was mainly a factor of increased investor awareness, which lead the company to trade at a more normal industry multiple.  I anticipate a similar story from Rand Worldwide. If the company can build on its revenue and profit momentum, I expect Mr. Kamin will list the company on a major exchange and allow the market to re-price Rand to an industry standard multiple. An EV/Revenue multiple of only 1.0 times current revenues would mean 68% upside for shares.

Or, he’ll take it private. He’s done that, too. Anybody remember Abatix? Also Kamin.

Of course, things might not turn out so rosily for Rand. If customers were to sour on Autodesk’s software offerings, demand for Rand’s training and management services would be impacted. It’s also possible that a bad economy could hurt revenues, or the company could make an ill-considered move into an industry where it lacks expertise.

All in all, I view Rand as a very cheap way to invest alongside a very shrewd operator in Mr. Kamin, and to take advantage of the company’s smart financial engineering before the market takes notice.

 

Alluvial Capital Managment, LLC holds shares of Rand Worldwide, 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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One for the Watchlist – Elders Ltd.

For the past few months, I’ve been watching with interest as an attempted business turnaround takes place in Australia. The company in question is Elders Ltd., a venerated agrobusiness that has fallen on hard times. Elders provides a suite of services to Australia’s rural wool and beef industries and farmers, including animal feed, wool trading, live export, and financial services. Elders’ lengthy history began in 1839, when Alexander Lang Elder traveled from Scotland to the new colony of Australia to expand his family’s merchant empire. The business took off, and over the next several decades Elders expanded into mining, wool trading, banking, brewing and other businesses. Elders underwent multiple restructurings, ownership changes and name changes, but finally returned to the public markets in 1993. Elders spent the 1990s and 2000s expanding some divisions and divesting others, but generally growing its balance sheet and taking on debt in the process.

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The Problem

The financial crisis hit Elders hard. Elders had invested heavily in its forestry operations for years, only to record hundreds of millions in writedowns. The company’s automotive assets began to bleed red ink as global demand for autos crashed. The company’s debt load threatened to drag it into bankruptcy, so in 2010 Elders proceeded to raise $500 million in equity, using the proceeds to pay down debt. Hopes that the restructuring would restore Elders to profitability were soon dashed. The years 2011 and 2012 saw the company report a  further $456 million in losses. Elders’ problems ran far beyond the balance sheet. The company had become a bloated, unwieldy conglomerate with entirely too many lines of business and too little accountability among them.  In 2012, the company’s marquee rural services unit earned an EBIT margin of only 1.6%. Forestry continued to produce losses and automotive limped along. The only bright spots were Elders’ equity investments in various insurance and banking companies.

From June, 2007 to October, 2012, Elders stock plunged 99%. What was once a vibrant company with revenues in the billions was now struggling for life as losses continued and the debt load remained unsustainably high.

Elders began divesting its forestry operations in 2011, and announced it would also divest its automotive holdings. In October, 2012, the company announced it would begin preparations for the sale of its rural services unit. It looked as if a very old business, once an Australian institution, would see itself parceled off to other firms, a victim of over-leverage and poor management.

The Plan

Ultimately, the sale of the rural services business was not to occur. Shareholder dissatisfaction reached a fever pitch, resulting in new management being installed in April, 2014. New CEO Mark Allison has extensive experience in agriculture, and revealed plans to return Elders to an agricultural pure play by selling off remaining non-core investments and focusing on increasing profitability in the rural services unit, with a focus on high-margin, asset-light businesses.

Elders has spent most of 2014 selling off remaining non-core assets (forestry, real estate, feedlots, and many other small operations) and applying the proceeds to reducing its term debt. Earlier this month, the company announced the final steps in this process: an equity raise via a share placement and rights issue, and a new debt package. As a result, Elders will have no term debt for the first time in decades, and will finally be able to focus on profitability and growth rather than survival.

Elders’ new management team has released detailed plans to increase profitability, and hopes to nearly triple EBIT by 2017. Before looking at those plans, let’s take a look at Elders’ new capital structure. Following the share placement and rights issue, Elders has 837.2 million shares on issue. At todays’ price of $0.175, that’s a market capitalization of $146.5 million. Elders also has a class of “hybrid equity” outstanding. This is essentially floating-rate non-cumulative preferred stock. Dividends have been suspended since 2009, and Elders will have to pay 12 months of delinquent distributions before it can declare dividends on common shares. Elders has $150 million par value of hybrid equity shares outstanding, and they currently trade at 55% of par. Following the equity raise, Elders has $21 million in net term debt. However, the company just closed on the sale of its 50% interest in AWH Pty Ltd. for $32.4 million in cash. Finally, Elders’ new banking facility provides up to $308 million in working capital financing, of which $145 million will be drawn.

Elders’ new capital structure and enterprise value look like this:

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In connection with its capital raising, Elders’ new management team released a detailed presentation outlining they steps they will take to increase profits and reduce capital requirements. Elders new focus will be on its highest-margin, most profitable business lines. Below are a few selected slides from recent presentations. The first two contrast Elders’ current lines of business with where the firm will now position itself.

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Achieving EBIT of $60 million and a return on capital of 20% by 2017 will require a mixture of improved sales margins and reduced corporate costs. Elders has set out its specific initiatives in all its business areas that it believes will help achieve these goals. The entire presentation is worth a read and can be found here.

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In my view, Elders’ decision to return to its strengths is a good one. Elders has been a constant presence in many of the rural communities that it serves for generations, and the brand recognition and relationships that come with that kind of longevity carry value. The company’s long experiment in empire-building has rightly come to an end with the company barely surviving the venture. Rebuilding Elders’ profitability requires a return to the company’s roots in serving Australia’s large agricultural sector in rural communities.

The Outcome

If Elders is successful in growing EBIT to the $60 million target, the returns to shareholders could be substantial. For 2014, the company has guided for pre-items EBIT of $23-28 million. At the mid-point, Elders trades at 14.2x 2014 adjusted EBIT. The company trades at only 6.0x its 2017 EBIT target.

Elders hasn’t revealed the cost of its working capital financing (that I can find) so I’ll use an estimate of the 1 year Australian government bond rate of 2.59% plus a 2% spread. I’ll also assume that Elders increases the draw on its working capital facility 5% annually, as sales increase. For the hybrid capital securities with a rate of the ten year swap rate plus 4.7%, I’ll use an estimate of 8.56%. Note that the hybrids cost is an after-tax expense, with Elders passing on franking credits to the holders. Assuming Elders can meet its 2017 EBIT goal in exactly three years, let’s estimate profits at that point.

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If Elders achieves its goals, it stands a chance of earning close to $24 million annually for shareholders. This is slightly misleading, however, as Elders will not likely be a taxpayer for quite some time. The company has accumulated deferred tax assets totaling $255.9 million. A simplistic way of valuing these assets is to assume they are used up linearly over 10 years, beginning in 2017. Even at a high discount rate of 11.56% (the hybrid capital cost +3%) this yields a present value of $44.2 million.

Elders’ 2017 value under all these assumptions depends on the multiple assigned by the market to the company’s pro forma earnings, but it’s not hard to arrive at a value much higher than today’s, even using modest multiples. The chart below shows Elders’s prices per share and three year compounded returns at various pro forma earnings multiples, including the present value of the tax assets.

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In reality all that matters is whether or not Elders can successfully achieve the goals it has laid out. If they do, the company will stop being valued as a distressed equity and will begin to be valued on an earnings/cash flow basis, and the share price will rapidly appreciate to some multiple of anticipated future profits. The chart above is mostly intended to illustrate what the magnitude of that appreciation could be based on various extremely uncertain scenarios that include a lot of my guesswork and crystal ball gazing.

On the other hand, if Elders’ new management team fails to make progress and investors lose hope, Elders shares will be in trouble as investors begin to contemplate yet more restructurings, write-downs and management turnover. Given the company’s troubled history, investors will understandably show little patience and won’t hesitate to punish the stock price if management’s confidence proves unwarranted.

For those inclined to take a flyer on a successful Elders turnaround, the hybrid capital securities are also an interesting bet. Management has guided for no distributions for at least a while as the company dedicates capital to rebuilding and re-positioning. However, at some point common shareholders will demand a dividend, and hybrid capital holdings will receive a year’s worth of skipped distributions. If the arrears payments equal roughly 8.56% of par, distributions take three years to resume and the securities trade at par when they do, investors buying at today’s 55% of par will earn a total return of 97.4% and a compounded return of 25.4%. That’s competitive with the equity on a risk-adjusted basis. Given the uncertainly of Elders’ ultimate turnaround, perhaps investing slightly senior to the common stock is wise.

Personally, I require more evidence of progress before giving Elders serious consideration as an investment. Though its short-term financial troubles have been assuaged by the capital raise, the company faces a difficult task in restoring its profitability and expanding its margins. Even if the next financial report’s numbers look good and the stock pops, there will be plenty of time to buy in before the potential returns lose their attractiveness. At least for now, Elders remains one for the watchlist.

Alluvial Capital Management, LLC does not hold shares of Elders Ltd.  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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Paul Mueller Company’s Ongoing Recovery – MUEL

A while back I wrote a post on Paul Mueller Company in which I highlighted the company’s promising improvements in profits and margins but expressed reservations about the company’s high financial leverage and large pension deficit. Ultimately, I decided the balance sheet issues were troubling enough to keep me watching from the sideline. Eighteen months later, the results are in.  Anyone who had disagreed with my assessment and bought shares is sitting on a whopping gain. From the end of April 2013 to the present, Paul Mueller shares rose 190% from $18.00 to $52.25.

The big move in Paul Mueller Company’s stock is due to the combination of vastly improved earnings and a de-risked balance sheet. At the time of my original post, I had pegged Paul Mueller’s adjusted 2012 operating income at $5.9 million. Since then the company has made great strides, growing trailing twelve month revenues by 7.5% to $193 million and nearly tripling operating income to $15.4 million. No need for adjustments either, as the severance expenses that depressed the company’s 2012 EBIT are in the rear-view mirror.

Improved profits aside, the company’s leverage has declined meaningfully. Total debt has been slashed by a third, falling from $34.2 million at the end of 2012 to $22.9 million as of June 30, 2014. The reduction was funded entirely through free cash flow, but not by sweating the company’s assets; capital expenditures have tracked with depreciation. The company’s pension deficit remains material, though it has also declined 40% since 2012. The decline is mainly due to strong appreciation in the pension plan’s equity investments. The expected return on the plan assets was held steady at 7.25% from 2012 to the present, though the discount rate on plan obligations was increased from 4.48% to 5.34%. (Increasing a pension plan’s discount rate results in lower present value of future payouts. Changing a discount rate is a totally legitimate response to changing long-term interest rates, but aggressive companies have been known to choose a higher discount rate in order to minimize reported pension deficits.)

Back, for a moment, to Paul Mueller’s greatly improved results. Recently installed CEO David Moore has made several comments about focusing on bringing each business segment into the black and making the heads of individual business lines responsible for results for the first time. The company has also implemented “open book management,” a concept designed to increase transparency, improve management/employee relations and help employees see how their individual contributions result in increased profits and their own rewards. In the 2013 annual report, Moore specifically mentioned the head of each business segment and credits strong performers. Results for the first half of 2014 are up substantially over the same period in 2013, with revenues up 13.5% and operating income up 23.3%. The company’s backlog is $70.4 million compared to $55.1 million one year ago, strongly suggesting continued improvement in trailing twelve months’ results.

Despite the run-up, Paul Mueller Company remains very reasonably priced. Including the reported pension deficit in the company’s enterprise value shows an EV/EBITDA figure of 5.0 and EV/EBIT of 7.0.

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These ratios are likely to fall if the company’s higher backlog results in increased earnings and as the company continues to apply its free cash flow to reducing debt.

Paul Mueller’s large pension deficit remains a risk, particularly now that equity securities comprise over 60% of pension assets. A weak stock market could undo much of the progress the company has made in reducing the size of its pension deficit. However, the vastly increased earnings and cash flow combined with significantly reduced debt make the pension much less of a concern than it was a year and a half ago. Paul Mueller Company’s ongoing debt reduction and improving earnings have shifted the risk-reward balance very favorably since I originally wrote about the company, and I no longer see compelling reasons to avoid the shares.

Alluvial Capital Management, LLC holds shares of Paul Mueller Company 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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Havyard Group ASA – Overlooked Recent IPO: HYARD.NO

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I’ve run across an interesting recent IPO by the name of Havyard Group ASA. Based in Norway, Havyard designs and builds specialty service ships. Havyard is majority owned by the Saevik family through their private company Havila ASA.

For completely unoriginal reasons, I rarely find IPOs worth investigating. Companies usually go public after a run of strong business performance and are priced for perfection, often resulting in disappointment if results show the slightest weakness. Also, many companies go public to raise funds to bridge over operating losses during their high-growth phase, and I tend to focus on mature companies that are already generating positive cash flow. However, neither of these factors applies to Havyard. First, Havyard is not riding high on a wave of growth. While still strongly profitable, the company’s results have actually dipped somewhat since 2012 highs. Expectations for Havyard’s future growth likely aren’t demanding. Second, Havyard’s IPO was an ownership shift, not a capital raise. The parent company, Havila, simply monetized a part of its investment in Havyard by offering it to the public. Havila CEO Pers Per Sævik released the following statement concerning the IPO:

”Our family has broad interests in the offshore supply industry. In light of this, and because we see that we need to optimise the conditions for continued growth for Havyard Group, both on technology and ship equipment, we choose to reduce our ownership. Havyard has a significant potential for growth, but the further development of the company requires more than we as a family company have the possibility to contribute.”

Havyard’s original intended IPO price was NOK 36.00, which was then discounted by 7% to NOK 33.50. The discounted IPO price reaffirms my belief that expectations and enthusiasm surrounding Havyard are not high. Since the IPO, shares have slipped another 4.5%.

Before discussing Havyard’s history and business segments, let’s review the company’s history in brief. Havyard was founded in 1999 in Norway and got its start building platform service vessels for the North Sea’s active offshore drilling market. Over time, the company expanded into various other types of specialty vessels and built up a world-wide clientele. Havyard has expanded beyond the oil and gas industry and now designs and manufactures ships for the fishing and aquaculture and offshore wind farm industries. The company expects these new markets to offer great growth potential. Havyard notes that most fish consumption is likely to increase substantially as the world’s population continues to increase and wild fisheries remain in danger of over-harvesting. Offshore windmills will only become more common and economical as wind technology improves and the world’s energy needs increase. Today, Havyard bills itself as a ship technology company focused on “Improving Life At Sea.” Havyard’s self-identification as a technology company is not mere marketing puffery; fully half the company’s operating income is earned by its ship and systems design segments.

Here’s an example of Havyard’s output. The Lewek Inspector is a 110 meter inspection, maintenance and repair vessel designed for fuel efficiency and maneuverability in rough conditions. It was delivered to Forland Shipping in late 2013.

Havyard has four operating segments. The largest by far is the “Ship Technology” segment, responsible for the actual construction of the company’s vessels. Havyard’s hulls are manufactured under oversight by a partner in Turkey, then tested and finished in Norway. This segment is responsible for the large majority of Havyard’s revenues, but only about half its operating income. Havyard’s “technological” segments, “Power & Systems” and “Design & Solutions” accounted for just 20% of the company’s 2013 revenues, but contributed 52% of operating income. The final segment, “Fish Handling & Refrigeration” is a newcomer. Havyard made its initial investment in this segment in 2012. Fish Handling & Refrigeration accounted for 14% of 2013 revenues, but scarcely contributed to operating income. While this segment currently does not provide much in the way of earnings, Havyard considers it a strategic segment with good growth potential. The chart below breaks out Havyard’s 2013 results by segment. The figures diverge slightly from the company’s financial statements due to slight differences in presentation methods and are shown in millions NOK.

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Havyard’s 2013 results were off somewhat from 2012, even though revenues increased substantially due to the acquisition of the fish handling and refrigeration segment. The company attributes the decline in margins and earnings to the expense of developing and producing product prototypes, though I suspect the company also willingly sacrificed some margin to win contracts that allowed it to expand into new industries. Perhaps not a bad long-term strategy, even if short-term results suffer. Nonetheless, the company remains solidly profitable. Management expressed satisfaction with results for 2013 and the first quarter of 2014, noting successes in attracting first-time customers and in delivering new vessel models on time and on budget. Financial results for the trailing four quarters through Q1 2014 as well as for 2013 and 2012 are presented below.

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Havyard’s balance sheet is healthy, with plenty of liquidity and net debt less than trailing EBITDA. Pinning down Havyard’s exact net debt is somewhat subjective due to the presence of substantial investments in associates. As of the end of 2013, Havyard listed a total of NOK 422.7 million in loans to and investments in associated companies, plus NOK 133.2 million unrestricted cash against total debt of NOK 295.2 million for net cash and securities of NOK 260.6 million. Assuming the level of restricted cash remained constant from the end of 2013, Havyard now has unrestricted cash of NOK 50.5 million after deducting dividends payable. The graphic below sets out the various assets and liabilities that go into estimating Havyard’s net cash and securities positions. “Other Non-Current Receivables” is Havyard’s term for long-term interest-bearing loans to asociates, the terms of which are set out in note 20 of the annual report. At quarter-end, Havyard had net cash and securities of NOK 34.4 million.

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At a recent trade price of NOK 32.00, Havyard’s valuation is enticing. The NOK 721.0 million market capitalization, combined with a positive net cash and securities position, yields an EV/EBITDA ratio of just 3.7 and an EV/EBIT ratio only slightly higher at 4.1. The company is cheap on an earnings basis as well at only 5.6 times trailing net income.

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These ratios are simply too low for a conservatively-financed, asset-light company with good prospects. I expect some raised eyebrows at my characterization of a shipbuilder as “asset light,” but you can check the financial statements to see for yourself. Depreciation accounts for less than 1% of Havyard’s annual revenues, an astonishingly low figure for an industrial company. In 2013, Havyard managed EBIT of NOK 180.6 million on average invested capital of only NOK 474.3 million, a 38.1% EBIT/Invested Capital figure. Havyard accomplishes this feat by outsourcing the capital intensive part of its manufacturing process, hull-building, to other companies.

Though Havyard’s low valuation and reasonably good business prospects support a valuation much higher than where shares currently trade, the company does face risks that must be evaluated. The primary risk is a slowdown in the global oil and gas industry, and in the North Sea in particular. Though it has had success in entering new markets, Havyard’s results are still sensitive to the level of demand for oil and gas support vessels. A sustained decline in demand would have a serious impact on Havyard’s results. The company also has large exposure to the performance of its associated companies, mostly ownership stakes in and loans to ships and shipping companies. The book value of these holdings is equal to 61% of Havyard’s current market value, so their performance may have a serious impact on Havyard’s results and value. If these assets perform poorly, large writedowns may result. Investors should also remember that Havyard remains a controlled company. Havila ASA has a long track record of success in the maritime industry, but investors still must trust the Saevik family to manage Havyard well.

Alluvial Capital Management, LLC does not hold shares of Havyard Group ASA for client accounts.

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