Algoma Central – TSX:ALC

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Algoma Central is a interesting little Canadian shipper and real estate operator with hidden assets and a profitable market niche. Founded in 1899, Algoma Central grew out of what was once the Algoma Central Railway and is controlled by one man, Henry N. R. Jackman.

Algoma, located in Sault Ste. Marie, Ontario, operates four different business units.

Domestic Shipping – Algoma owns a fleet of dry bulk carriers that operate in the Great Lakes and Canada’s eastern seaboard. These ships transport dry bulk commodities as well as liquid petroleum products. Algoma has begun a program to replace older ships with new, technologically-advanced vessels. The first of eight of these, the Algoma Equinox, was delivered in September, 2013. For reporting purposes, Algoma separates the results of the dry bulk and tanker fleets.

Ocean Shipping – Algoma has a partial interest in four self-unloading carriers, direct ownership of two more and direct ownership of a tanker. The main cargo for these ocean-going ships is coal, crushed aggregate and gypsum. Algoma outsources the management of these ships to other firms with expertise in ocean shipping.

Ship Repair – Algoma owns a ship repair facility located in Port Colborne, Ontario, on Lake Erie. Algoma does not report the results of the facility separately.

Real Estate – Algoma Central owns 1.3 million square feet of commercial real estate in the Sault Ste. Marie, St. Catharines and Waterloo, Ontario areas. These properties include a hotel, a mall and several office buildings. Occupancy is strong and the properties have substantial value.

Though the shipping industry is cyclical, Algoma Central has been consistently profitable. The great lakes shipping industry is a small and specialized segment of the global shipping complex, and has been somewhat sheltered from effects of over-building and massive rate fluctuations that have plagued the world dry bulk and tanker markets.

Here are Algoma’s recent results, presented in Canadian Dollars:

Algoma Results

A few things become apparent when surveying these results. First, Algoma is not a rapid growth organization. While not the disaster that global dry bulk and tanker shipping has been since 2008, the Great Lakes shipping market is a slow-growth market. Second, Algoma Central is capital intensive. For the twelve trailing months, the company recorded $46 million in depreciation, or 8.8% of revenues. Capital intensive companies are not necessarily poor investments, but their large capital needs make capital allocation policy even more important. Investors must be able to trust management to make sound investments in fixed assets and anticipate business cycles.

Because Algoma Central has multiple lines of business with unique economics, an examination of each segment is due. For cyclical industries like shipping, looking at only the most recent results can paint a false picture of profitability. Using long-term returns on assets to estimate normalized profitability can give a better idea of a business line’s economic potential.

Shipping

First, we’ll tackle the company’s largest segment by revenues and assets, domestic dry-bulk. Here are figures for the segment beginning in 2005, the year that Algoma changed to its current segment reporting structure. Note: Algoma has undertaken a series of joint venture consolidations and other corporate actions resulting in restating past results. I have used results as of the year they were published, without adjusting for restatements.

domestic dry

Clearly, the domestic dry-bulk segment is deeply cyclical. From 2004 to 2012, the company’s EBIT yield on average fixed assets employed averaged 8.91%, ranging from a high of 18.56% in 2007 to a low of -0.99% just two years later. Since the period included the most severe recession since the Great Depression itself, the average EBIT yield may be understated. However, the figure remains a useful and conservative estimate of normalized return on assets for the segment.

Algoma’s second-largest shipping business is its product tankers operation.

product tankers

Since 2005, the product tanker segment’s profitability has sunk to the mid single-digits, even as Algoma tripled its investment in the segment. For the whole time period, EBIT yield averaged 8.60%, though the average was only 4.49% from 2008 on. Despite this period of low returns, there are some reasons to believe the segment can produce an average EBIT yield greater than it has averaged in recent years. 2012 results were greatly affected by legal fees related to canceled ship orders. Absent these charges, the EBIT yield on average fixed assets would have been greater than 6.5%. Disregarding the mid-crisis years of 2009 and 2010 and assuming 2011 and 2012 results are more typical, a 6.00% normalized EBIT yield is a fair and conservative estimate of normalized profitability.

Algoma Central’s ocean shipping is its smallest shipping segment, but by far its most profitable.

ocean shipping

The ocean shipping segment leaves the others in the dust with an average EBIT yield of 17.28% over the last eight years. Once again assuming the poor 2009 result was an anomaly, I believe an 18.00% EBIT yield is a reasonable estimate for the segment’s long-term normalized profitability.

Having estimated the productivity of each segment, the next step is to project EBIT based on the assets of each segment.

EBIT projection'

Based on my conservative estimates of shipping segment profitability, Algoma’s normalized EBIT from these business lines is $59.40 million, an EBIT yield of 9.03% on fixed assets employed. The actual EBIT yield produced by these assets in the twelve trailing months was just under 8.00%, indicating that Algoma’s shipping assets are currently under-earning compared to projected long-term averages.

Real Estate

Luckily, estimating the value of Algoma’s real estate assets is a simple process. We could arduously calculate net operating income and determine cap rates, or we could simply use the fair value that the company has provided in its 2012 annual report: $165 million. This figure is $93 million higher than book value and represents one of the company’s hidden assets.

Cash, Debt And Pensions

Algoma’s balance sheet holds $138.74 million in cash and equivalents, but this amount is under-stated by $41.70 million due to the company’s other hidden asset: refunds received from two Chinese banks on canceled ship orders. These refunds represented down payments on three tanker ships originally ordered in 2007. When Algoma canceled the orders in 2010 based on excessive delivery delays, the Chinese builders claimed the cancellations were invalid and refused to return the deposits. The matter went to arbitration and a London tribunal ruled in Algoma’s favor in April and UK commercial courts denied the builders appeal and Algoma received $41.70 million at the very end of 2013. This figure does not yet appear on Algoma’s balance sheet beyond a $33.94 “recoverable vessel deposits” entry. Including the refunded deposit, Algoma’s total cash is $180.44 million.

Algoma’s debt and dividends payable totals $226.81 million. Its pension deficit is $18.32 million. The company’s net debt and pensions is $64.69 million.

Enterprise Value and Valuation

Algoma Central’s market capitalization is $610.92 million CAD. By determining enterprise value and backing out the real estate value, the market’s valuation of Algoma’s shipping operations can be seen.

valuations

 

At 9.30x normalized shipping EBIT, Algoma looks…..fairly valued. Of course, it is possible that my estimate of long-term EBIT yield is too conservative since it includes a period of near economic meltdown. On the other hand, conservatism is every value investor’s friend. I’d rather invest in something that trades at a discount to conservatively estimated fair value than make aggressive assumptions and hope I was right. Unless Great Lakes shipping demand picks up dramatically in the short-term, Algoma seems likely to provide average returns. I’d certainly rather hold Algoma than any of the world’s many over-leveraged, unprofitable shippers, but I’d much rather wait for the next time Algoma trades at a mid-single digits multiple of normalized EBIT.

I hope readers who primarily drop by to read about dirt cheap stocks are not disappointed by the conclusion. (I think I have profiled enough of those to earn an indulgence post or several!) In my view, there is always something to be learned from researching a stock, even when the company turns out to be fairly or even richly valued. For instance, in the course of researching Algoma I learned a great deal about the various classes of ships that transport commodities up and down the Saint Lawrence Seaway, about the various operating models that shippers in that market use, and even something of the economic history and present situation of the Sault Ste. Marie area. All useful facts for a value investor to squirrel away. Much of success in investing is simply learning as much as possible about industries and economies and then using that knowledge to better perceive value.

No position.

Hennessy Advisors, Inc. – HNNA

Time to discuss one of my biggest missed opportunities of 2013: Hennessy Advisors. In late 2012, Hennessey completed a transformational acquisition that was highly likely to increase the company’s earnings and share price, which was then hovering around $3. I looked into the projected earnings (though perhaps not as thoroughly as I should have), even read a nicely-written summary that was circulating in the value investing community, and then did absolutely nothing. Imagine my chagrin to see the company rise and rise to its current level around $12 on the basis of greatly improved earnings and a bright outlook.

So why choose to discuss Hennessy Advisors? As worthwhile as conducting post mortems on one’s missed opportunities can be, I know most readers drop by my humble blog for profiles of interesting and obscure companies that may offer strong investment potential. Despite Hennessy’s strong run since late 2012, I view Hennessy Advisors as under-valued and yet to achieve a fair valuation, based on its extremely attractive business model and operational momentum.

First, a little history. At the end of 2005, Hennessy had $1.83 billion under management, and earned 53 cents per share in the fiscal year ended September 30, 2005. Earnings would move higher for the next two years, but assets under management peaked at $2.25 billion in early 2006 before beginning a steep decline. Investors began to withdraw their funds in the third quarter of 2007 as the severity of the economy’s troubles came into focus. From then through the first quarter of 2009, Hennessy’s woes were compounded by investment losses in its funds of $725 million. From there, the company’s funds began to reverse their investment losses, but the damage was done. From the end of 2005 to June 30, 2012, Hennessy’s investors withdrew a total of $1.22 billion. Despite positive investment returns of $47 million through the entire period and purchasing funds with another $233 in assets under management, Hennessy’s assets under management were cut by more than half to just $821 million.

Hennessy’s earnings and stock price had plummeted from their 2006 highs, but the company hatched an idea. In late June, 2012, Hennessy announced it would acquire the FBR family of mutual funds. The ten FBR funds had $1.9 billion in client assets, which would immediately more than triple Hennessy’s managed assets. The price of the acquisition was projected to be $28.75 million, with 60% to be paid up front and the remainder to be paid on the first anniversary of the deal’s close. The price of the remaining 40% would be calculated on the assets under management at that point. Hennessy funded the purchase price mainly through a line of credit.

The deal closed on October 26, 2012. By then, strong investment returns had lead the value of the FBR funds to rise to $2.22 billion. Hennessy folded three of the former FBR funds into existing Hennessy funds, and renamed the other seven. With its new, expanded pool of assets under management, Hennessy’s profits increased and its stock was off to the races.

Since the transaction closed, Hennessy has continued to add to its assets under management through market appreciation and through investor inflows. Assets under management surpassed $4 billion for the first time at quarter’s end.

aum growth

While the FBR funds purchase is the major contributor to Hennessy’s AUM growth over the last year, the company has also enjoyed market appreciation in its funds of $649 million. Retail investors (ever buying high and selling low) have began piling back into equity funds, making Hennessy’s funds the recipients of a net $243 million in the same time period.

Hennessy’s $4 billion in assets under management are divided among 16 different mutual fund offerings, but two funds purchased from FBR account for over half of these assets. Each of the two funds has an outstanding long-term track record and excellent recent performance, which has driven investor inflows.

funds offerings

 

The Hennessy Focus Fund has exceeded other funds in its category by 3.00% annually for the past ten years. The Fund has been sub-advised by Broad Run Investment Management, LLC since 2009. The fund’s AUM increased 68.1% from October 31, 2012 to October 31, 2013 on the strength of strong investment returns and high inflows.

The Hennessy Gas Utility Index Fund has exceeded other funds in its category by 3.01% annually for the past ten years. Morningstar ranks the fund number 1 in its category for the 3 and 5 year trailing periods.

Of course, a mutual fund’s good historical performance is no indication of superior future returns. However, a good track record (especially strong recent performance) is a powerful marketing advantage, and mutual funds distribution is all about marketing. A very large cohort of investors select mutual funds investments on the basis of performance alone. The fact that Hennessy’s two flagship funds have performed so well will help keep shareholder funds rolling in.

Hennessy’s results since the acquisition of the FBR funds show just how transformational the purchase was for Hennessy. Fourth quarter 2013 operating income rose nearly fivefold from fourth quarter 2012 results.

quarterly results

 

Strong as the most recently reported quarter was, there is ample reason to believe the first quarter of fiscal 2014 will be even better. Since September 30, 2013, the S&P 500 Index has risen 10% and investors have continued to pour new money into equity funds.

Luckily for us, Hennessy explicitly discloses the management fees it receives for each of its funds. Using Morningstar estimates of assets under management in each fund, we can predict Hennessy’s quarterly revenues.

revenue prediction 2

Because of continued market appreciation and investor inflows, Hennessy’s revenues will likely increase by more than 15% in the first quarter of fiscal 2014. This figure excludes revenue from 12B-1 fees, because the company does not disclose enough information to estimate them accurately.

But it’s not all positive news. Hennessy’s operating expenses will rise as well. Several of the company’s funds are sub-advised, and those sub-advisory fees will rise as AUM grows. Hennessy discloses these fees as well.

subadvisory fees

 

When Hennessy Advisors reports its first quarter results, sub-advisory fees will likely rise over 17% from the previous quarter’s $1.17 million. Other operating expenses are less certain, but conservatively assuming 10% increases in each category still results in a 24.30% increase in operating income.

projected quarterly

 

Once operating income has been projected, projecting net income is only a matter of deducting interest expense and taxes. In in the 2013 annual report, the company revealed it had paid the remaining 40% purchase price for the FBR funds in November. The price was $19.19 million, $13.29 million of which Hennessey funded using a loan. Hennessey’s total debt is now $36.06 million, bearing interest at 4.00%. Hennessy’s effective tax rate has hovered around 40%. The chart below shows projected annualized results based on projected first quarter 2014 figures.

annualized projection

At its current level of assets under management, Hennessy could earn $7.49 million over the next year, or $1.29 per share. This figure does not include the effects of continued inflows or potential market appreciation. If these trends continue, earnings per share could go much higher. Investor inflows in particular are likely to continue as strong recent performance for the Focus and Gas Utility Index funds draws attention. Retail appetite for mutual funds tends to lag market movements, which suggests that equity fund inflows will continue in the short run.

valuation

 

At its current price, Hennessy Advisors trades at 7.62 times my estimate of forward EBIT and 9.35 times forward earnings. Once again, these estimates are conservative and do not include the effects of market appreciation or continued inflows.

The chance to buy an asset management company at under ten times earnings is rare. Because the asset management business model is so attractive, asset managers rarely trade a so cheaply. Consider how many other businesses have the opportunity to grow revenues in the high single digits annually simply through market growth, and require practically no additional capital to do so?  A look at Hennessy’s publicly-traded competitors shows just how under-valued Hennessy appears to be in comparison. The chart below shows forward valuations for all the US asset managers for which I could find 2014 earnings estimates.

comps

 

Using my conservative earnings estimate, Hennessy trades at a 50% discount to peer valuations.

Of course, there are a few factors that could halt Hennessy’s earnings growth and keep it from reaching valuation parity with its larger competitors. First, markets could take a dive, reducing AUM and Hennessy’s fees revenue. Hennessy’s funds are nearly exclusively equity funds, which would suffer worse than the fixed income funds that other companies offer. Second, Hennessy’s fund managers could lose their way and the funds could begin to underperform, which would also cost the company revenues and assets under management. Investors are always looking for the next hot investment and have little patience for lagging mutual funds. Also, the ongoing trend away from actively managed funds and toward ETFs could reduce investors’ appetites for Hennessy’s and other companies’ offerings. (Though conversely, greater and greater degrees of passive investing will increase opportunities for active investors, which could improve the performance of actively-managed funds.)

None of these risks are unique to Hennessy, so I see no reason why the company ought to remain so cheap compared to competitors. Perhaps a small discount for Hennessy’s small size and concentrated fund portfolio is warranted, but not 50%. As Hennessy’s AUM and earnings grow, investors could see Hennessy’s stock appreciate to more reasonable levels.

 

Disclosure: No position.

Avangardco’s Rock-Bottom Valuation and Dividend Initiation Could Send Shares Higher, But Risks Remain – London:AVGR

Hello, and happy New Year! To start 2014 off right, I’ll be profiling Avangardco Investments Public Ltd, the top producer of eggs and egg products in Ukraine and the surrounding region. Despite great operational success and strong growth, Avangardco trades at an absurdly low multiple of earnings and assets. Avangardco is set to begin paying dividends in 2014, which may cause the market to re-evaluate the company’s prospects. Despite its strong fundamentals, Avangardco also carries substantial risks. The company’s primary place of business is Ukraine, not one of the world’s more stable economies. Avangardo’s leading export markets are various Middle Eastern nations, including Iraq and Syria. Finally, the company is nearly 80%-owned by a Ukrainian billionaire, Oleg Bakhmatyuk. No worrisome related-party transactions are disclosed by the company, but Mr. Bakhmatyuk seems to be a “colorful” character based on some googling. Given the reputation of Eastern European and Russian billionaires, the risk of corruption and management pocket-lining is elevated.

Background

Avangardco’s business operations are located in Ukraine. Ukraine has historically been one of the world’s most agriculturally productive nations, earning the nation the nickname “The breadbasket of Europe.” While the USSR was in existence, Ukraine was responsible for 25% of total Soviet agricultural output. Today, Ukraine remains a major food exporter to Russia, the European Union and the Middle East.

Ukraine’s tax policies strongly encourage the expansion of the agricultural industry. Companies that earn 75% or more of their revenues through agriculture are no subject to corporate income tax, but instead pay a de minimus Fixed Agricultural Tax based on farm acreage owned or rented. Agricultural business are also not required to remit Value-Added Tax revenue to the government, but can instead retain it for use in developing additional capacity. This special VAT treatment is scheduled to continue until 2018. For more information on Avangardco’s tax treatment, check out this PDF from Deloitte.

While Ukraine’s fertile lands and highly advantageous tax regime make it an attractive place to do business, the unstable political atmosphere should lead investors to approach with caution. Ukraine is locked in an ideological struggle between those who would look Westward and make progress toward greater unity with the West and eventual EU membership, and those who would have closer ties with Ukraine’s ancient sometimes-ally, sometimes-enemy, Russia. Until the struggle is resolved, investors will rightfully apply a political risk discount to Ukrainian assets. If the struggle ends in a move toward Russia and Russian-style oligarchy and klepto-capitalism, this discount may become permanent.

Avangardco went public in 2010, offering 1.39 million new shares for proceeds of $208 million. These proceeds were used to fund capacity expansion. The company had previously been re-structured in 2009, when crushingly bad economic conditions and a high debt load necessitated a debt for equity swap. Avangardo’s GDRs stake on the London Stock Exchange with the ticker AVGR.

Business Operations

In 2012, Avangardco’s flock included 27.5 million hens which produced 6.3 billion eggs. The company included several interesting charts in recent reports which sum things up better than I ever could, so I am reproducing them below.

value chain

Avangardco’s vertically-integrated structure reduces costs and makes the company the low-cost producer in its markets.

market position

 

Avangardco is Ukraine’s market share leader in all of its markets, both domestic and export. The company has a near monopoly in dry egg products, and is responsible for 90% of Ukraine’s egg and egg products exports.

Avangardco’s export operations have really picked up steam, climbing from 18% of sales in the first nine months of 2012 to 32% in the first nine months of 2013.

import export

 

Since 2009, Avangardco has expanded its export operations to 33 international markets.

geomarkets

 

Financial Results

Since its 2010 IPO, Avangardco has produced impressive growth in revenue and profits, while maintaining strong margins. (Reported EBITDA is higher than reported gross margin because the VAT credit the company receives is added back to EBITDA.)

financial results

 

Despite its strong profits, free cash flow has been consistently negative since the IPO. While ordinarily this negative free cash flow would be a concern, Avangardco has had a strong set of growth opportunities which have required significant capital expenditure. That capital expenditure has proven fruitful, with revenue growth of 47.8% and net income growth of 24.2% since 2010. The full benefit of Avangardco’s capital program has yet to been fully reflected in results, as the company is working to complete three projects: the Avis egg production complex, the Chornobaivske egg production complex, and the Imperovo Foods egg processing plant. Once these projects have been completed, Avangardco will be able to house 30.1 million egg-laying hens and will increase its egg production capacity by 36.5% to 8.6 billion per year.

Despite the large capital expenditure program, Avangardco’s balance sheet remains healthy and net debt is only 0.63x EBITDA. Liquidity is very good with a current ratio of 4.45, and equity represents 77.8% of total capital.

balance sheet

Valuation

Avangardco’s valuation is among the lowest I have encountered. The company’s P/E ratio on trailing earnings is 3.20, and its EV/EBITDA ratio is 3.16.

valuation

 

As cheap as Avangardco appears to be on an earnings basis, the company is just as cheap on an asset basis. Avangardco’s book value per share is $20.29, and virtually all of that is tangible. At the closing trade of $11.50, Avangardco trades at a discount to book value of 43%.

Even with its potential risks, a little over 3x earnings/EBIT/EBITDA appears far too cheap for a growing enterprise with a dominant market position and little financial risk. Investors may begin to overlook some of their fears once Avangardco begins paying out dividends. In September, the company announced it had decided to adopt a dividend policy and to pay out 15-40% of earnings each year, subject to the availability of cash and striving for long-term dividend stability and growth. At the same meeting, the company elected to set 2014 dividends at 25% of 2013 net income.

If next quarter’s results are in line with previous quarters, Avangardco will earn $229.52 million this year, or $3.59 per share. 25% of that figure would be $0.90 per share in dividends, good for a yield of 7.8%.

In Summary

Avangardco’s risks are real and include a potentially unstable Ukrainian economy, a high-risk majority owner and a dependence on nations in conflict as major export customers. However, the company also possesses a leading market position, great growth potential and firm financial footing. Combined with a rock-bottom valuation, a dividend initiation at a healthy yield and increased earnings from completed projects, Avangardco’s shares could move much higher in 2014.

An account I manage holds shares of Avangardco Investments Public Ltd.