Why I Invest In Unlisted Stocks: A Case Study

I invest in unlisted stocks for a number of reasons.

One, I like the thrill of the hunt. Finding these tiny but successful companies is a blast and a great antidote to the boredom that comes of hearing the same ten large cap company names over and over again every trading day. Is anyone else already tired of reading about Apple’s bond issuance or JC Penney’s dire straights?

Two, I like being a little different. It’s a wild world out there! The S&P 500 constituents are dull! Why not buy some shares in your local community bank instead? Or in a tiny widget manufacturer and then call up the CFO and shoot the breeze?

Third, the returns! Nowhere else have I found such abundant opportunities to buy companies at a fraction of their listed competitors’ valuations. On average, the investor who pays $1 for an asset will fair much better than the investor who pays $2 for a substantially similar asset.

To illustrate my point, let’s look at a company I own and have written about before, Alaska Power & Telephone. APT shot the lights out in 2012. Here are just a few of the company’s accomplishments.

  • Achieved record net income of $2.55 per share.
  • Achieved record free cash flow of $5.61 per share.
  • Repurchased 10.4% of shares outstanding, reinstated a dividend and grew book value per share by 7.3%.
  • Reduced net debt 8.2% to $59.4 million. Net debt/EBITDA and debt/equity are at their lowest in the past decade.

The first quarter of 2012 saw further increases to net income and book value and another $1.3 million shaved from net debt.

Despite this laundry list of accomplishments, APT’s stock price has not so much as budged. Net income continues to rise and net debt continues to fall and the market takes no notice. The result is a company that trades at barely half the valuation of comparable listed competitors.

APT’s revenues are roughly 60% electrical power generation and transmission and 40% telecommunications services. Generating a comparison to peers is as simple as pulling up valuation statistics for utilities and telecom providers and weighting them appropriately.

The chart below compares valuations, yields and leverage for these industries, based on the trailing twelve months. The average telecom services EV/EBITDA multiple is actually 8.32. Since the index includes firms with wireless assets and APT has none, I reduced theĀ  the multiple by 2.00 to 6.32. This aligns fairly well with reality. Even troubled traditional telco Cincinnati Bell trades higher at at 6.86 times trailing EBITDA.

val comparison

On average, a business that is 60% electrical utility and 40% traditional telco would trade at 8.35 times EBITDA and carry net debt of 3.29 times EBITDA. APT is much, much cheaper.

val comparison 2

Despite being only slightly more leveraged than our hypothetical competitor, APT’s valuation on an EV/EBITDA basis is 40.5% lower. To trade at the industry average valuation, APT stock would have to rise to $62.29, more than triple its current price.

All right, so APT does have a few weaknesses. It is geographically confined to an area of low population density and a harsh climate. The stock is illiquid. On the other hand, how many other utilities and telco firms are gobbling up their own shares while also reducing debt and earning record income and free cash flow? Moreover, APT’s power generation facilities are mostly hydro-electric, leaving them immune to the threat of input cost inflation or the environmental issues of coal plants.

Even at just 80% of the valuation of its competitors, APT would be worth $41.18, 111% higher than today’s price mid-point of $19.50.

Many investors view the unlisted markets as the exclusive domain of fraudsters and stock manipulators. And there are those. But there are also scores of profitable, well-run companies waiting to be discovered.

I have a position in Alaska Power & Telephone.

 

 

15 Comments

  1. Great post! I completely agree, why pay more for similar assets or earnings. The extra premium is a listed premium, as a business owner why should we care about prestige of listing? It’s like private company owners claiming their company is better than a competitor because the CEO belongs to a better country club.

    The argument is investors can’t get out of unlisted companies, yes it takes longer but other options exist. Many unlisted companies will privately negotiate to buy back a shareholder position, try that with Xerox..

    Nate

  2. Hi

    How are you sure that the market will eventually discover its value ? May be this is the right discount fo the lack of size, liquidity and the inability to scale ? Would love to hear your experience as to what gives you conviction that you can get out in the OTC market by selling a chunky block, say 1-2% ?

  3. Hi

    Please enlighten us on why you think this will eventually get fairly priced ? May be this is teh right discount for liquidity, lack of scalability etc.

    And what gives you confidence that you will be able to sell a meaningful chunk of stock in an OTC counter ? Also, please do enlighten me on how the price discovery in the OTC exchange works given the lack of liquidity

  4. After looking through their reports, I noticed a very large portion of their debt (approx $50 Mill) is going to have its interest rate increased in a few months by 2% due to an interest rate swap from 2009. this will reduce pre-tax earnings by about $1 Mill a year. Any thoughts on this? Do you think they will be able to refinance?

    • Sharp eyes and a good point! I ran the numbers to figure out just how much the higher interest rate will cost. Based on its current amortization schedule, APT will have about $45.3 million in CoBank debt as of August 1, 2013. At that point, the amortization schedule will change from 25 years to 10 years, with payments increasing accordingly. Based on the old 5.65% rate, monthly repayments will be $495,000 monthly. Under the new 7.62% rate, payments will be $540,000 per month.

      For the 12 months following August 2013, APT will incur interest expense of $3.34 million under the new 7.63% rate. Interest expense under the old rate would have been $2.47 million. These figures take monthly principal reductions into account. The difference before tax is $0.87 million. Assuming 35% tax, the additional after-tax interest expense is $0.57 million, or 42.5 cents per share. So yes, that’s a big deal. The good news is that’s the worst of it. In years following the first, debt amortization will gradually narrow the difference.

      I think APT’s chances of refinancing the debt are fairly poor, mostly because to do so it would have to pay off the swap liability associated with the debt. Currently, that liability is $8.59 million. I suspect APT will have to bite the bullet and focus on paying down the debt and improving operations.

      Even if APT’s earnings are hit by increased interest expense, the company remains much cheaper than competitors and could still support much higher dividends.

      Thanks for the great comment.

  5. European companies offer the same thrill and “Underwood” feeling that the American OTC markets give.
    For example in Denmark there are a lot of companies that are equally thinly traded, family owned and incredibly cheap.

    One such company is Arkil A/S.
    Take a look: http://www.arkil.dk/ANNUAL%20REPORTS-1471.aspx

    Traded on:
    http://www.nasdaqomxnordic.com/shares/shareinformation?Instrument=CSE3332

    I have been owning this company since 2011, i bought it at 1/3 of tangible equity.

    Because of the rising market our world is becoming smaller by the week. But there are still companies out there that is priced the same as they where in the financial crisis. It just takes a lot longer to find them,

    Some of you might complain about the A and B share structure. But if you study the management family closely, you will see that it’s nothing to be afraid of.

    Greetings from Norway.

    • Arkil seems very cheap. I enjoy hearing about smaller family-controlled companies. If the family has the interests of all shareholders in mind, these companies can make great investments.

  6. Great idea and great article. I’m not aiming to rain on your thesis here, but I just want to hear what you think about this. This is my take, though I surely haven’t done as much research as you have.

    From what I can tell, the company has been spending almost all of its free cash flow over the pat 10 years on reducing the debt. That’s why it didn’t pay a dividend.

    The company’s been growing at about the rate of inflation. There was a return from such growth of about 2.2-3.3% over 1997 to 2012.

    The debt-to-equity ratio is still much more than what I see the typical utility set at (1.85 for APTL versus 1.00-1.25 for the average), but the new dividend policy set in 2012 gives hope that they might ramp this dividend up in the next few years. So maybe that would be a catalyst for a share price increase?

    Well, I’m not sure. The typical utility has a dividend yield — at today’s interest rates — of about 4-5%. This would most likely increase if general interest rates increased.

    So if you take APTL’s free cash flow or net income of about $2,700,000, deduct from this the typical payout ratio of a utility, which is about 60-70%, so let’s say 65%, then you have a potential dividend of $1,755,000.

    Capitalize that at 5% and the value is $35,100,000. Capitalize it at 6%, and you have $29,250,000.

    What is the error in my line of thought here? Much appreciated if you help me out here.

  7. Any reason not to include the interest rate swap in the EV calculation? I realize it fluctuates, perhaps discounting the swap would be okay, but I would not exclude the entire amount.

    I don’t love comparison analysis, only that I think 8x EV/EBITDA multiple is too high. APTL is a buy in my opinion, but the main reason is that there is little downside risk with potential for upside. I think the value comes over time as APTL keeps buying back stock each year and paying down debt.

    My thought is that with the leverage if the market suddenly starts showing some ‘love’ for APTL, EV/EBITDA goes to 6x and the stock increases by 50%.

    Jack, I think the numbers you used initially are too low. Net Income is closer to 3.5MM and FCF is higher 7.5MM. If you exclude working capital changes, FCF is closer to 6-6.5MM. Using 50% of Net Income would be above 5% yield (1.75MM/28MM market cap) or even higher with FCF numbers.

    • You can make a good argument that the swap should be included. However, it truly is “phantom debt” that will disappear as soon as the swap expires. Of course, the company’s cash interest expense will increase when that happens, but the absolute debt balance will not be affected.

      I am also typically skeptical of comparison analysis. I prefer my holdings to be cheap in absolute terms. I chose to include the comparison to show how little respect the market affords APTL’s operations compared to competitors in the same industries. Some of that is warranted, given APTL’s leverage and small size.

      You make a good point concerning the leverage. It may increase APTL’s cost of equity, but it will also increase stock returns if the market decides to tack on another one or two turns of EBITDA to the company’s valuation.

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