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.

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.

Capital Drilling – CAPD:L

Now that I’ve done a few consecutive posts on US companies, I hope my readers will indulge me as I profile another foreign stock. Today’s topic is Capital Drilling, a former high-flier that now trades at a discount to asset value. Capital Drilling’s earnings have suffered along with other terrestrial drillers, but the company is in fine position to weather the slow period with little debt, a modern fleet and multiple contracts with blue-chip operators.

Capital Drilling owns a fleet of drilling rigs that it provides to mining companies. The company focuses on emerging and frontier markets, with the large majority of its rigs operating in Africa. These rigs are contracted to major operators such as BHP Billiton, Kinross, and Barrick. Capital owns six different categories of drilling rigs, all suited for different types of drilling activity such as blasting and grading. Capital Drilling was founded in 2004 with only a few rigs, but the company now owns 96. Capital Drilling went public in 2010, using the IPO proceeds to expand its drilling fleet. Capital Drilling also provides drilling management and communications services, though the great majority of revenues and earnings are attributable to its rigs.

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Rocketing gold prices following the financial crisis had Capital Drilling riding high. Its rigs were in great demand and the company enjoyed high utilization and contract rates. Revenues and earnings rose steadily as the company expanded its fleet. However, it was all too good to last. Gold prices took a tumble, leading miners to curtail their exploration and production programs. Capital Drilling’s rig utilization fell from the upper 80%s to below 50%, and operating income dropped to nil. Below are figures showing Capital Drilling’s results for the past five years. Note the extent of the drop-off in revenues and earnings in 2013, the price of gold having fallen 25% during the year. Figures are in USD, Capital Drilling’s reporting currency.

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While 2013 was undoubtedly a disappointing year for Capital Drilling, a few factors helped keep the company alive to drill another day. First, Capital Drilling never leveraged itself to the hilt in order to build its fleet. Even at its most leveraged, Capital Drilling’s net debt never surpassed 22% of equity. While competitors were forced to scramble to stay solvent, Capital Drilling simply used its operating cash flow to reduce its net debt as business slowed. At year end, the company’s net debt stood at only 10% of equity. Second, Capital Drilling’s young, efficient fleet allowed it to maintain a higher utilization ratio than its competitors. As of year-end, the average age of the company’s rigs was only four years. In any commodities slow-down, the first projects to be mothballed are those with the highest operating costs, and the same holds true for drilling equipment. Capital Drilling’s ability to offer more efficient, reliable rigs than its competitors enabled it to keep more of them in the field and earning income while its competitors’ rigs sit rusting.

All this is not to ignore the fact that 2013′s results were decidedly uninspiring. Rig utilization for the year may have been higher than competitors’, but was still just 55%. Fortunately, there are signs of improvement in Capital Drilling’s fortunes. The company has not yet released official results for the first half of fiscal 2014, but it has released interim trading updates. These reflect multiple positive data points.

  • Revenues for the first half of 2014 were approximately $52.9 million, an increase of 21% over the second half of 2013. The company is nowhere close to achieving its previous revenue highs, but the boost in revenues is an encouraging sign that the worst of the washout in mining activity is over.
  • Average revenue per operating rig rose to $194,000 in the second quarter of 2014, compared to $186,000 in the same quarter a year earlier. This 4.3% increase helps the company’s margins, even as utilization rates remain tepid.
  • The company won two new five year contracts, one a drilling contract for AngloGold Ashanti in Tanzania, and the other a production contract for Centamin in Egypt. The company spent $11 million acquiring suitable rigs for these contracts, but still managed to avoid increasing its leverage.
  • The company expects strong free cash flow in the second half of 2014, having already completed most of its capital expenditures for the year.

So what’s Capital Drilling Worth? Shares currently trade hands at 28.5 GBp, giving a market cap of £38.4 million , or $64.5 million. At year-end, Capital Drilling had a tangible book value of $88.4 million. The company’s current trading price represents a discount to tangible book value of 27%. Assuming the company’s cash and receivables are worth book value, the current market cap implies a haircut of 41% to the book value of Capital Drilling’s rigs and rig-related assets. That figure might make sense for distressed rig operator with poor quality, aging rigs, but I’d argue it’s far too conservative for a modern fleet like Capital Drilling’s. If Capital Drilling is capable of earning its cost of capital over time (and I believe it is) then the proper value of the company is much closer to the book value of its assets.

Alternatively, we can value Capital Drilling by normalizing its return on invested capital and comparing the company’s current enterprise value against normalized operating income. From 2010 through 2013, Capital Drilling’s EBIT/Invested capital (which I am defining as EBIT/(Net Debt+Equity)) ranged from -0.2% to 37.6%, averaging 22.6%. These figures represent both boom and bust years, so we can reasonably assume the company’s long-term average ROIC will fall between these numbers. I shy away from choosing a number toward the top of that range, believing gold’s rocket trajectory from 2006 to 2012 to be something of a fluke and not likely to be repeated any time soon. That said, I also believe it to be unlikely that Capital Drilling will stagger along earning mid single-digit returns on capital indefinitely. Such poor returns over a long enough period of time would decrease rig supply and tilt the competitive balance more toward rig owners’ favor, sending ROIC numbers upward. I think the most likely case is the Capital Drilling’s long-term return on invested capital settles between 10% and 15%, neither of which is an aggressive figure.

The chart below illustrates Capital Drilling’s implied valuation at various long-term ROIC rates.

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At a very modest normalized pre-tax EBIT/Invested Capital estimate of 10%, Capital Drilling’s implied valuation is an undemanding 7.3x normalized EBIT. In this case, 10% is a very conservative estimate of ROIC, as the standard post-tax ROIC calculation would be well below 10%. Higher but still quite reasonable estimates of 12.5% and 15% imply bargain EV/Normalized EBIT ratios of 5.9 and 4.9 respectively.

Capital Drilling’s short-term returns will likely be determined by levels of mining activity in Africa and by the movement of gold prices, but today’s price may represent an attractive value for long-term investors. Buying well-financed cyclical companies during business troughs can often work well, provided investors forecast normalized earnings power conservatively and management is reasonably competent.

 

Alluvial Capital Management, LLC does not hold shares of Capital Drilling Limited for client accounts.

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

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

 

Pope Resources Offers Cheap Inflation Protection: POPE

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

 

 

 

North State Telecommunications Corporation – NORSA/B

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

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

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

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

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

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

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

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

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

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

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

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Blog and Business Updates

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

The Business

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

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

The Blog

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

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

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

Teak Holz International AG – Vienna Exchange: TEAK

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

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

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

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

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

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

Possibility #1Overstated Assets

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

Possibility #2 – Financing Issues and Dilution

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

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

Possibility #3 – The Market is Wrong

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

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

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

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

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

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

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

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

Results and Outlook

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

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

Improving Balance Sheet

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

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

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

 Valuation

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

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

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

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

Risks

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

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

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

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

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Pental Limited – PTL:ASX

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

Holland Colours NV – HOLCO:Amsterdam

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

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

Holcobatch

Holcobatch

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

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

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

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

Holco has used its copious free cash flow to chip away at its debt, resulting in a much more stable and sustainable company. Should another crisis or extended recession come along, Holland Colours will likely fare much better than it did the last time around.
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Now for a look at Holco’s valuation. As I write, the company has a market cap of EUR 25.8 million. However, only about EUR 5.8 million worth of shares are free floating. Just over half the company’s shares are controlled by Holland Pigments BV, in which many Holco employees are invested. (In all, Holco employees own 21% of the company.) Various other institutions own large blocks of shares, leaving only 22.6% of the company’s shares available for investment. The micro float of an already microcap company may partially explain Holland Colours’ low valuation.

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

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

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

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

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

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

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

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

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.

 

An Unlisted Eccentric – ACMAT Corp. ACMT/ACMTA

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

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

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

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

Capture

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

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

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

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

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

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

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

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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.