I feel like this story has been presented ad nauseum. So prepare to throw up. Everyone knows about AIG and what an awful company it was. On the flip side, value investors are pouring over it. I think this would qualify as a Michael Burry "ick factor" stock. In fact, I think that everything is overblown and a margin of safety exists that may be greater than any other insurance company out there. More so than even my favorite, Aspen.
There are four inputs to this: Insurance segment (Chartis/SunAmerica), management, the government, and everything else (all the auxiliary lines of business/wind-downs/IPOs).
Chartis
Personal and Commercial insurance arm of AIG. They will not win an award for being the best insurance company but they are certainly one of the bigger ones. In Q1 2012 they wrote $8.8B worth of net premiums and had a pre-tax income of $910M. They underwrote to a loss, so investment income was $1.2B for the quarter.
They returned $1B to the parent in Q1 2012 and $1.5B in FY 2011. Management expects Chartis to return between $2.5-4.5B to the parent in 2012. This is off $124.9B of total invested assets as of Q1 2012.
While I'm not overly impressed with their loss ratios it's not a total train wreck considering all the catastrophes the past two years. I give Chartis a "C" for a grade (average for those conditioned to grade inflation).
SunAmerica
This is their retirement and annuity branch. In Q1 2012 it returned $1.6B to the AIG parent. In the Q4 2011 earnings call management expected SunAmerica to return about $2B to the parent. This is off $192.8B of total invested assets as of Q1 2012.
SunAmerica is big, well known, and probably here to stay. With a fair amount of ignorance I would apply a "C" to SunAmerica as well.
Insurance Segment
Combined Chartis and SunAmerica have total invested assets of $317.7B. Backing out debt and reserves and everything else one arrives at a BV of ~$83B. Management expects annual dividends from their operating companies to come in at $4-$6B. This would obviously correspond to an ROE in the mid-single digits. Just like every other insurance company, AIG has "aspirational goals of 10% ROE."
I believe that in today's low rate environment, coupled with the insurance industry surplus this segment is worth 0.9BV or $75B. Perhaps that will improve in the future but for now I'll stick with a bland 0.9 assessment.
Management
In Andrew Sorkin's "Too Big to Fail" I remember when Lehman Brothers, hoping for a liquidity injection, sent Buffett an annual report and other documents. Buffett read them and made a note of anything he didn't understand. Supposedly the report was littered with notes by the time WEB was done reading it. Confusing annual reports are not good.
Financial companies are opaque at best. Reading an annual report should clear and concise.
Reading AIG's most recent annual report was a breath of fresh air. Everything was spelled out. Does this eliminate long tail risk? Of course not. I can only hope that the team hired to clean up the mess created in the crisis will actually clean up the mess. They are experienced insurance executives and they seem committed to returning money back to shareholders. Up to $30B by the end of 2015.
Everything Else
This will be a gross oversimplification but here goes.
ILFC: Looking at Whitney Tilson's presentation I think it's reasonable to believe that ILFC is worth book value. The S-1 for ILFC shows shareholder equity of $7.6B(pg 44).
Maiden Lane III: AIG received $5.56B on July 12th. They'll now get 33% of the remaining equity Conservative value = $5.56B
AIA Stake: Obviously this will fluctuate with the market. As of March 31, 2012 their remaining interest in AIA was ~$8.2B. With roughly 290M shares held this has declined in value to roughly $7.8B as of 7/16/2012.
I have ignored the other assets, such as United Guaranty, deferred taxes, etc. I think that "Everything Else" is worth $20-$21 billion. It could be worth more and perhaps in a serious market swoon/IPO bust it's worth significantly less. Again, my hope is that this is conservative.
The Government
The Treasury owns 61% of the shares outstanding. With roughly 1 billion shares and a break even price of $28.72 there's a worry that the stock price will be stuck at the break even price as the Treasury unloads shares on the market. Management knows this is the belief widely held.
"Conventional wisdom has been, as long as the treasury has a large position $29 is probably the ceiling for the stock.'' Robert Benmosche Q1 2012 Earnings Call
I have no idea what the end exit strategy for the government will be. Quite frankly, I don't care as long as they exit sometime soon, which is the stated intention.
So why do I believe AIG is a buy?
First, there is a skewed shareholder base. The Treasury owns 61% of the shares, Fairholme owns another 5%. Therefore, 66% of all shares are held by two groups. One group doesn't care that much about selling price. This would be an inefficiency. What fund manager would want to be caught owning AIG while the Treasury also owns shares?
Pretty much just Bruce Berkowitz and friends.
In small cap stocks large ownership stakes sometimes present inefficiencies. In this case we know that the Treasury wants to sell their stake. They are a forced seller. The exact details aren't known but as I've said earlier, we know they are exiting. Once the Treasury exits fund managers around the world can start buying. I believe this makes AIG act like a small cap that has a strange shareholder base.
If we believe that "Everything Else" is worth $21B and the core insurance business of AIG can make $3-$7B a year (3%-8% ROE) today's it's easy to see why Benmosche thinks that they can return $30B to shareholders in the next three years. As the Treasury exits shares should get bought back.
Will things change once the Treasury's stake drops below 50%? Yes I would imagine. Luckily we have the other banks that took TARP funds as a road map. They made it out OK and I think AIG will too.
The second reason I believe AIG is a buy comes from the margin of safety. The company is priced as if no other business segment ("Everything Else") has any value. Today's valuation gives the insurance segment alone a P/BV 0.67 ($58.7B MC $83B BV). I find it absurd that ILFC, ML III, United Guaranty and everything else has zero value. Even if it does you still get SunAmerica and Chartis at a discount.
Is that discount warranted? No, I think there is excellent clarity in conference calls, annual reports and public messages. Thanks to the Joe Cassano PR campaign, AIG is combed over by everyone. Luckily for us, the AIG of today is not the AIG of 2007. Once the government exits and non-core businesses are sold you're left with a large insurance company.
I think it's reasonable to value the insurance companies at $75B (explained earlier as 0.9BV) and "Everything Else" at $20B in value. AIG, in my eyes would be fairly valued at roughly $51 per share(1.875B shares 95B fair value).
Conclusion
In 2007 AIG was spread out and had it's hand in numerous cookie jars. Many of these jars had mousetraps and as a result AIG suffered. The company is completely different now and poised to return $30B to shareholders in three years.
Buying AIG at a discount today lets investors participate in a clear path to accretive book value growth. As the Treasury exits I believe management will buy back shares. This will grow BV and enhance the upside while reducing the downside of government intervention. This will also lift the stigma associated with owning common shares. Instead of a government backed entity you will have an insurance company selling for about 1/2 book value that generates 3%-8% ROE on an annual basis.
While there are many risks to this investment I believe the clear path forward and the deep discount to conservative book value is a compelling opportunity. Long AIG
Tuesday, July 17, 2012
Tuesday, June 12, 2012
Kronos (KRO)
Background:
A lot has been written about titanium dioxide (TiO2)and the run up in prices. High cost suppliers shut down production during the depths of the financial crisis and Tronox went bankrupt. Once the dust settled, prices skyrocketed and now it seems as though there are monthly TiO2 price increases. Dupont, Cristal, Kronos, Tronox, and Rockwood are enjoying massive profits on limited supply and typical demand.
I have reviewed several TiO2 companies and believe that Kronos represents the best opportunity right now. They are one of the few pure plays to TiO2 and have been unduly punished due to the European Crisis. On top of that management thinks like owners.
Business:
Kronos has six TiO2 plants and a total capacity of 533,000 tons/years split 75:25 between chloride and sulfate routes. Two of their plants are in North America and the others are in Europe. They also own and operate an ilemnite (raw material for sulfate TiO2 production) mine in Norway, supplying 10% of the worlds supply of ilmenite (and all of the their sulfate European production).
Management:
Harold Simmons is the Chairman of the Board. Mr. Simmons is a simple man, he loves TiO2 and hates President Obama.
Regardless of his political tendencies, he has been buying shares just about as quickly as he has been donating to conservative Super PACs. If that's not conviction I don't know what is. Directly and indirectly he owns about 95 million shares of Kronos.
Unlike his LBO days, he left Kronos relatively unleveraged ($481.5M in total debt). His conviction, track record in business, and insider buying are a moderately positive sign for the individual investor. There do seem to be multiple related party transactions. I can't say Simmons gets me excited as a leader but his influence hopefully is waning.
CEO, Steven Watson, has been buying shares often in the open market and owns over 128,000 shares. Mr. Watson was made CEO in 2009 right around the time Tronox went bankrupt. He was with the company "during the last big upsurge" (Q4 2010 conference call) and seems to understand the perils of too much capacity. The scars from the 1990's have clearly impacted Mr. Watson.
Each swoon that beats the stock down results in another round of insider buying. While insider buys are not something to rely on, I think they are a positive sign.
Favorable Economics
Much has been written about TiO2 and how the prices will just keep going up. I have no idea if prices will keep going up. I can make a couple of reasonable assumptions that indicate Kronos will remain an attractive investment for several years.
1. There's almost no real TiO2 capacity coming online. No good ones anyways. Supposedly there are plants coming online in China, I put that in the "I'll believe it when I see it" category. Regardless, there is plenty of technical knowledge involved with TiO2 production, something the Chinese recognize. The incremental improvement by first tier firms will likely only keep up with the expected increase in demand and not surpass it.
There have been no green field announcements and these plants take about four years to build according to Kronos(Q4 2010 Conference Call). Those that choose to invest will need to be sure that they can get adequate returns. Kronos has stated multiple times that a new 150,000 tpa chloride plant will cost upwards of $1B. An investment that takes four years to build will need assurance that pricing will remain strong.
Some estimate that TiO2 demand will reach 6-7.5 million tons per year. The upper range will only occur if all plants come online(expected by 2015 at the earliest). I'd say those estimates are a little aggressive as current worldwide demand stands at roughly 5 million tons per year. I would imagine TiO2 demand would track global GDP growth. If all that capacity comes online and works as expected it may result in lower TiO2 prices.
The take home point here is: capacity will not just pop up overnight. The capacity that is coming is several years away, so I believe pricing for TiO2 will remain strong for at least a couple of years.
2. Feedstock capacity is easy to bring online. Kronos has said so themselves on multiple occasions and it makes sense. Titanium and iron are everywhere, you just need capital to mine it.
Steve Watson talked about feedstock constraints in 1H 2012. This was expected to ease in the second half of 2012. No matter what feedstock ends up costing it doesn't matter, there's no capacity leftover in pigment production and thus far pricing increases have been passed on with ease.
There is feedstock production coming online and a lot of capacity can be brought on quickly. Mines in Madagascar, Mozambique, and other countries are expected to start producing ilmenite in excess of pigment capacity, depending on demand projections. Ilmenite is used in the sulfate production method and thus lower quality and doesn't have the same pricing power as rutile.
As reference, if TiO2 demand hits 6.2 million tons per year feedstock demand will need to be around 7.3 million tonnes per year (Arkitol).
3. The last titanium dioxide cycle was long. Peaking in the early 1990's it destroyed pigment manufacturers until plants were closed permanently. The reason it's such a long cycle is simple, plants take time to build and only a few players have the technical knowledge. Most of the plants that are being built now, whether in China or elsewhere, will take several years to build.
In the late 1980's (the last cycle peak for TiO2) gross profit margins hit 50% and EBITDA margins were in the 45% range (Q4 2010 KRO Earnings Call). I think this is a good proxy for what levels would have to hit before new plant expansion happens. Currently KRO has gross margins of 61.4% (1,194M gross profit in 2011) and EBITDA margins of 30.8% (600M in 2011).
What's it going to earn and why is it so cheap?
I lack the ability to know exactly what TiO2 pricing is going to be but let's take a base case scenario.
In Q1 2012 the company generated $561M in revenue COGS were $299.8. There have been two price increases that will raise prices by ~10%. If no other price increases occur revenue will be ($561*1.1) times 3 quarters plus $561 for Q1 2012 revenue. Revenue for 2012 will be $2.412B.
Per Kronos conference calls, COGS will rise by 50-60%. If that's the case then COGS will be ($299.8M*160%)* 3 quarters (9 months left in 2012) plus Q1 2012 COGS of $299.8M. COGS for 2012 will be around $1.738B.
Our base case gets us gross profit of $674M. This trickles down to roughly $317M in net income ($195M for SG&A and $25M for interest and $137M for taxes at 30% ). Let's call it $300M because it will take a couple of months for those price increases to hit and SG&A will probably go up. With 115.9 shares outstanding that's EPS of $2.58. With the share price hovering around $16, plus or minus a lot depending on Spain's weekly bond auction/bailout, that puts it 6.2X earnings.
I think that's a little pessimistic though. While a meteoric rise in prices like 2011 is unlikely (40% YoY increases) I feel confident that 1. feedstock costs will moderate and 2. TiO2 prices will increase. How much I don't know.
The central thesis for me here though is that if ore prices go through the roof and pigment pricing stays the same we're looking at a company that still has a good shareholder return. Even if prices decrease and feedstock prices stay elevated you still will get a good return.
For what it's worth, I think that Kronos will generate around $3-4/share in earnings for 2012. I used 60% ore increases and TiO2 price increases of 10-20% (~11% has already occurred this year at Kronos, Cristal looks like their are leading the industry with more increases, there are some reports that Western European pricing is softening though). Finally I ramped up SG&A $5M and backed out $25M in interest expense.
So I believe I'm buying a business for 5-6X earnings. Some of these estimates are based on talks with contacts in the paint and chemical industry, some are just plain old estimates.
My final point for how cheap it is focuses on replacement cost. Steve Watson has said a couple of times that it would cost around $1B to build a 150,000 tpa chloride plant. Kronos has 400,000 tons of chloride production. The replacement costs of their chloride plants is $2.6B. This makes no allocation for their sulfate production or mine in Norway. All this for a company that can be bought for $1.8B plus some debt.
Depending on the scenario you believe will occur, Kronos is kinda cheap, or stupid cheap. The question is, why?
I think most investors are concerned with the recent bankruptcies, plant closures, and Europe. The bankruptcy concern is dumb because Tronox went bankrupt for legacy environmental issues (which were made impossible to overcome by crappy TiO2 economics). Baupost owns Tronox now so I feel their chance of going back into bankruptcy is slim.
Plant closures happened to the higher cost providers, Kronos has new plants and vertical integration that may help slightly. I didn't factor this is because mining revenues are only a couple of percent of their revenue at best. Also ilmenite pricing hasn't been as strong as rutile and probably will only get weaker as new capacity comes online.
It really seems to trade with Europe though. Oh no Spain needs a bailout?! Sell KRO!!
Yes, a significant amount of their plants are in Europe but they have two large plants in North America and their product could easily get shipped elsewhere. I believe that European fears are unfounded for a commodity like TiO2 and that demand may weaken slightly but will not crater. One cannot just stop using TiO2 (Everybody loves off-colored clear plastic). Short interest is pretty high for this name, at 5.05 days to cover. I wasn't able to find any solid short thesis on Kronos but I would love to see one. This will be an important discovery for the thesis.
I will admit I don't like some of their inter-party transactions. They are not large enough to worry me for now, but I will keep an eye on them. Hopefully Watson continues to plow ahead and run a profitable business leaving Simmons to attend Tea Party rallies.
Conclusion:
I have spent quite a bit of time looking at this, I originally started researching the different TiO2 players around November. To me the thesis is simple: demand is going to remain relatively stable and there is almost no significant capacity coming online for the next 3+ years. In the meantime the earnings power of these businesses will keep rising. Is this a hold for 10 years? Probably not.
I doubt demand for TiO2 will fall off a cliff but the strength of Kronos' balance sheet and high quality plants lets me sleep at night. This thesis does depend on TiO2 pricing staying constant and perhaps increasing slightly.
Kronos offers a compelling risk/reward due to solid insider management, a supply/demand imbalance and powerful profit generator for several years. It will be crucial to monitor new plants and capital expansions. As with everything, if Europe really goes to hell in a hand basket this bet would probably tank as well. Long KRO
Update 7/10/2012
Iluka had a conference call yesterday saying they were revising down production targets.
"We think, for example, chloride pigment producers, who are clearly important to us, have reduced their production by somewhere around 25% in the US and in Europe, and their forecast production
similarly, obviously.
Sulphate pigment production is also down, although we think by not as much as margins are
actually better in that segment versus chloride." David Robb Managing Director
So if Kronos lowered production by 25% in the 2nd half they should produce around 200,000 tons this year (I've ignored whether or not it's Cl2 or sulphate for simplicity). Iluka's conference call seemed to believe that it was more inventory control. So it could be a small cyclical downswing or a canary in the coal mine. We'll see.
Dupont and Tronox came out today swinging saying that Iluka's comments weren't indicative of their business and this is an over reaction. Dupont believes 2H 2012 pigment demand to be strong. So who knows, conflicting news in some ways but in other ways it supports my thesis. I believe the most prudent decision is to simply sit and wait for earnings.
A lot has been written about titanium dioxide (TiO2)and the run up in prices. High cost suppliers shut down production during the depths of the financial crisis and Tronox went bankrupt. Once the dust settled, prices skyrocketed and now it seems as though there are monthly TiO2 price increases. Dupont, Cristal, Kronos, Tronox, and Rockwood are enjoying massive profits on limited supply and typical demand.
I have reviewed several TiO2 companies and believe that Kronos represents the best opportunity right now. They are one of the few pure plays to TiO2 and have been unduly punished due to the European Crisis. On top of that management thinks like owners.
Business:
Kronos has six TiO2 plants and a total capacity of 533,000 tons/years split 75:25 between chloride and sulfate routes. Two of their plants are in North America and the others are in Europe. They also own and operate an ilemnite (raw material for sulfate TiO2 production) mine in Norway, supplying 10% of the worlds supply of ilmenite (and all of the their sulfate European production).
Management:
Harold Simmons is the Chairman of the Board. Mr. Simmons is a simple man, he loves TiO2 and hates President Obama.
Regardless of his political tendencies, he has been buying shares just about as quickly as he has been donating to conservative Super PACs. If that's not conviction I don't know what is. Directly and indirectly he owns about 95 million shares of Kronos.
Unlike his LBO days, he left Kronos relatively unleveraged ($481.5M in total debt). His conviction, track record in business, and insider buying are a moderately positive sign for the individual investor. There do seem to be multiple related party transactions. I can't say Simmons gets me excited as a leader but his influence hopefully is waning.
CEO, Steven Watson, has been buying shares often in the open market and owns over 128,000 shares. Mr. Watson was made CEO in 2009 right around the time Tronox went bankrupt. He was with the company "during the last big upsurge" (Q4 2010 conference call) and seems to understand the perils of too much capacity. The scars from the 1990's have clearly impacted Mr. Watson.
Each swoon that beats the stock down results in another round of insider buying. While insider buys are not something to rely on, I think they are a positive sign.
Favorable Economics
Much has been written about TiO2 and how the prices will just keep going up. I have no idea if prices will keep going up. I can make a couple of reasonable assumptions that indicate Kronos will remain an attractive investment for several years.
1. There's almost no real TiO2 capacity coming online. No good ones anyways. Supposedly there are plants coming online in China, I put that in the "I'll believe it when I see it" category. Regardless, there is plenty of technical knowledge involved with TiO2 production, something the Chinese recognize. The incremental improvement by first tier firms will likely only keep up with the expected increase in demand and not surpass it.
There have been no green field announcements and these plants take about four years to build according to Kronos(Q4 2010 Conference Call). Those that choose to invest will need to be sure that they can get adequate returns. Kronos has stated multiple times that a new 150,000 tpa chloride plant will cost upwards of $1B. An investment that takes four years to build will need assurance that pricing will remain strong.
Some estimate that TiO2 demand will reach 6-7.5 million tons per year. The upper range will only occur if all plants come online(expected by 2015 at the earliest). I'd say those estimates are a little aggressive as current worldwide demand stands at roughly 5 million tons per year. I would imagine TiO2 demand would track global GDP growth. If all that capacity comes online and works as expected it may result in lower TiO2 prices.
The take home point here is: capacity will not just pop up overnight. The capacity that is coming is several years away, so I believe pricing for TiO2 will remain strong for at least a couple of years.
2. Feedstock capacity is easy to bring online. Kronos has said so themselves on multiple occasions and it makes sense. Titanium and iron are everywhere, you just need capital to mine it.
Steve Watson talked about feedstock constraints in 1H 2012. This was expected to ease in the second half of 2012. No matter what feedstock ends up costing it doesn't matter, there's no capacity leftover in pigment production and thus far pricing increases have been passed on with ease.
There is feedstock production coming online and a lot of capacity can be brought on quickly. Mines in Madagascar, Mozambique, and other countries are expected to start producing ilmenite in excess of pigment capacity, depending on demand projections. Ilmenite is used in the sulfate production method and thus lower quality and doesn't have the same pricing power as rutile.
As reference, if TiO2 demand hits 6.2 million tons per year feedstock demand will need to be around 7.3 million tonnes per year (Arkitol).
3. The last titanium dioxide cycle was long. Peaking in the early 1990's it destroyed pigment manufacturers until plants were closed permanently. The reason it's such a long cycle is simple, plants take time to build and only a few players have the technical knowledge. Most of the plants that are being built now, whether in China or elsewhere, will take several years to build.
In the late 1980's (the last cycle peak for TiO2) gross profit margins hit 50% and EBITDA margins were in the 45% range (Q4 2010 KRO Earnings Call). I think this is a good proxy for what levels would have to hit before new plant expansion happens. Currently KRO has gross margins of 61.4% (1,194M gross profit in 2011) and EBITDA margins of 30.8% (600M in 2011).
What's it going to earn and why is it so cheap?
I lack the ability to know exactly what TiO2 pricing is going to be but let's take a base case scenario.
In Q1 2012 the company generated $561M in revenue COGS were $299.8. There have been two price increases that will raise prices by ~10%. If no other price increases occur revenue will be ($561*1.1) times 3 quarters plus $561 for Q1 2012 revenue. Revenue for 2012 will be $2.412B.
Per Kronos conference calls, COGS will rise by 50-60%. If that's the case then COGS will be ($299.8M*160%)* 3 quarters (9 months left in 2012) plus Q1 2012 COGS of $299.8M. COGS for 2012 will be around $1.738B.
Our base case gets us gross profit of $674M. This trickles down to roughly $317M in net income ($195M for SG&A and $25M for interest and $137M for taxes at 30% ). Let's call it $300M because it will take a couple of months for those price increases to hit and SG&A will probably go up. With 115.9 shares outstanding that's EPS of $2.58. With the share price hovering around $16, plus or minus a lot depending on Spain's weekly bond auction/bailout, that puts it 6.2X earnings.
I think that's a little pessimistic though. While a meteoric rise in prices like 2011 is unlikely (40% YoY increases) I feel confident that 1. feedstock costs will moderate and 2. TiO2 prices will increase. How much I don't know.
The central thesis for me here though is that if ore prices go through the roof and pigment pricing stays the same we're looking at a company that still has a good shareholder return. Even if prices decrease and feedstock prices stay elevated you still will get a good return.
For what it's worth, I think that Kronos will generate around $3-4/share in earnings for 2012. I used 60% ore increases and TiO2 price increases of 10-20% (~11% has already occurred this year at Kronos, Cristal looks like their are leading the industry with more increases, there are some reports that Western European pricing is softening though). Finally I ramped up SG&A $5M and backed out $25M in interest expense.
So I believe I'm buying a business for 5-6X earnings. Some of these estimates are based on talks with contacts in the paint and chemical industry, some are just plain old estimates.
My final point for how cheap it is focuses on replacement cost. Steve Watson has said a couple of times that it would cost around $1B to build a 150,000 tpa chloride plant. Kronos has 400,000 tons of chloride production. The replacement costs of their chloride plants is $2.6B. This makes no allocation for their sulfate production or mine in Norway. All this for a company that can be bought for $1.8B plus some debt.
Depending on the scenario you believe will occur, Kronos is kinda cheap, or stupid cheap. The question is, why?
I think most investors are concerned with the recent bankruptcies, plant closures, and Europe. The bankruptcy concern is dumb because Tronox went bankrupt for legacy environmental issues (which were made impossible to overcome by crappy TiO2 economics). Baupost owns Tronox now so I feel their chance of going back into bankruptcy is slim.
Plant closures happened to the higher cost providers, Kronos has new plants and vertical integration that may help slightly. I didn't factor this is because mining revenues are only a couple of percent of their revenue at best. Also ilmenite pricing hasn't been as strong as rutile and probably will only get weaker as new capacity comes online.
It really seems to trade with Europe though. Oh no Spain needs a bailout?! Sell KRO!!
Yes, a significant amount of their plants are in Europe but they have two large plants in North America and their product could easily get shipped elsewhere. I believe that European fears are unfounded for a commodity like TiO2 and that demand may weaken slightly but will not crater. One cannot just stop using TiO2 (Everybody loves off-colored clear plastic). Short interest is pretty high for this name, at 5.05 days to cover. I wasn't able to find any solid short thesis on Kronos but I would love to see one. This will be an important discovery for the thesis.
I will admit I don't like some of their inter-party transactions. They are not large enough to worry me for now, but I will keep an eye on them. Hopefully Watson continues to plow ahead and run a profitable business leaving Simmons to attend Tea Party rallies.
Conclusion:
I have spent quite a bit of time looking at this, I originally started researching the different TiO2 players around November. To me the thesis is simple: demand is going to remain relatively stable and there is almost no significant capacity coming online for the next 3+ years. In the meantime the earnings power of these businesses will keep rising. Is this a hold for 10 years? Probably not.
I doubt demand for TiO2 will fall off a cliff but the strength of Kronos' balance sheet and high quality plants lets me sleep at night. This thesis does depend on TiO2 pricing staying constant and perhaps increasing slightly.
Kronos offers a compelling risk/reward due to solid insider management, a supply/demand imbalance and powerful profit generator for several years. It will be crucial to monitor new plants and capital expansions. As with everything, if Europe really goes to hell in a hand basket this bet would probably tank as well. Long KRO
Update 7/10/2012
Iluka had a conference call yesterday saying they were revising down production targets.
"We think, for example, chloride pigment producers, who are clearly important to us, have reduced their production by somewhere around 25% in the US and in Europe, and their forecast production
similarly, obviously.
Sulphate pigment production is also down, although we think by not as much as margins are
actually better in that segment versus chloride." David Robb Managing Director
So if Kronos lowered production by 25% in the 2nd half they should produce around 200,000 tons this year (I've ignored whether or not it's Cl2 or sulphate for simplicity). Iluka's conference call seemed to believe that it was more inventory control. So it could be a small cyclical downswing or a canary in the coal mine. We'll see.
Dupont and Tronox came out today swinging saying that Iluka's comments weren't indicative of their business and this is an over reaction. Dupont believes 2H 2012 pigment demand to be strong. So who knows, conflicting news in some ways but in other ways it supports my thesis. I believe the most prudent decision is to simply sit and wait for earnings.
Monday, May 14, 2012
Dacha Strategic Metals CVE:DSM
Dacha Strategic Metals (DSM) trades rare earth elements(REE). It's a simple business. A couple of years ago they believed that REE prices would spike. In anticipation they bought up a bunch of REE, especially Heavy REE. They now store these metals and try to sell them. There have been a few sales over the past couple of years, a many of them in 2010 at lower prices.
The rarity of sales are surprising when we consider the price appreciation of rare earths. What is management waiting for? Another parabolic price increase in rare earths? In any parabolic curve one risks tremendous downside with an extended wait. Ask all the oil speculators who waited for $200/bbl oil in 2008. Still waiting.
So with that said, the starting point is knowing whether or not Dacha is a $1.00 dollar selling for $0.50 (or $0.94 of assets per share selling for $0.38/share 5/11/2012).
With thinly traded assets I believe acting as the end user is prudent. I always remembered Michael Burry's Mortgage CDS trade. Essentially, the quoted price didn't reflect reality. So what would I pay for each rare earth if I was an end user and needed it?
Dysprosium oxide: Currently dysprosium oxide is being held with a value of $16.8M. They have 15,000 kg giving a spot price of $1,118/kg. It is listed at 3N purity (99.9%). The exact purity is questionable though as it was listed at 4N in September.
I was able to get a couple of bulk quotes of dysprosium oxide.
"We can offer Dysprosium oxide, 99.99% (Dy2O3/REO), $1390/kg" -a US based company
I got an offer from the same company for 99.9% Dy2O3 for $1190/kg.
aliexpress gives a quote of $1,140/kg for a purity that isn't quite known (2N-3N5).
When everything is all said and done, channel checking showed dysprosium oxide is likely held at fair value.
Terbium oxide: Currently terbium oxide is being held on the books of Dacha's balance sheet at $29.1M. They have 14,000 kg giving a spot price of $2,075/kg. It is listed at 4N+ purity (99.99%).
"Terbium Oxide Powder TbO, 4N Purity 906 grams @ $5.10/gram = $4,620.60"-US Based company
"For your information, our current price for Terbium Oxide 99.99% 5kg is at USD5,150.00/kg"-Chinese company
The US company above told me that they couldn't offer larger quantities of terbium, they only sell by the gram. Which is interesting because another company also sells terbium oxide 4N by the gram. When I went to check out, 25g was only $40 ($1600/kg).
Finally a fourth, US domiciled, company offered large quantities of terbium oxide for $1,635/kg. Same purity Dacha has, 4 weeks to delivery.
This should be pretty easy to figure out who I would order material from.
I understand that terbium is not quoted often. But if I was a large end user of terbium oxide (the typical customer of Dacha) I would probably call around. After calling around, I would purchase terbium from the cheapest and most reliable terbium provider in a country with good business practice.
I may be biased though. I had several occasions in my old job where after ordering from Chinese companies we realized "greater than 99% pure" meant a couple of % of bug legs. If I can get a cheaper product from the US it's not even a question of who I would order with.
As far as DyFe goes I had difficulty securing quotes. I can't say one way or another if the value of the inventory is high or low. Using historical Shanghai Metals Market data for dysprosium iron alloy (2,650,000 RMB/MT or ~$420/kg with conversion rates today) suggests they held it higher than what it was actually worth(recorded at $525/kg on Dacha's balance sheet as of 3/10/2011). Unsurprisingly there was a 20% premium baked into this (similar to the other metals). Perhaps this is due to the Chinese export tax. But obviously this can't be completely true since I was able to source material in the US.
DyFe, Dy oxide, and terbium oxide make up 90% of the inventory. I believe that the prices given by Dacha are somewhat optimistic. We'll need to estimate book value if this is simply asset arbitrage. As of 4/30/2012 they had metals and cash worth $88.6M ($0.94/share, 94.3M shares fully diluted). They have liabilities of $1.6M. So book value as stated is ~$87M as of the linked May 3rd release.
Let us exercise the thought that the metals inventory may be bought at lower prices. We'll also use updated inventory figure(5/11/2012, REE prices are declining). If we lop off 20% for the DyFe inventory (held at $17.1M) and terbium (held at $29.1M) we find a "conservative" value of $36.96M (46.2*80%). Add back $23.5M (the other metals), $7.3M for cash and subtract $1.6M for total liabilities and we arrive at a book value of $58.3M.
I discarded all other assets as they were small and consisted primarily of a loan payable from Forbes and Manhattan Co, which has with no revenues or assets. In their 2010 annual report there's ample evidence of poor prior investments. I believe their acquisitions of rare earth metals proves that even a blind chicken gets feed occasionally.
Conclusion
There are simply too many moving parts to consider this a simple investment. While the simpleton in me says this is an asset play there are big hurdles to overcome.
First, management lacks discipline and seems to be using this as a personal vehicle. The Forbes and Manhattan Loan is just one example. The rallying cry is that the Chairman is a significant owner.
Well, so what? He also has a directorship with more than 20 companies(Dacha 2010 Annual Report). If this fails he'll just move on to the next company, where I'm sure he has a plethora of options. Head's he wins, tails we lose.
Their history is nothing spectacular and I have little reason to believe in their leadership. This has been well documented by other bloggers.
Second, my research shows that I can get some metals at lower prices. Chinese restrictions or not, I had no problem getting terbium, their largest stockpile, at lower prices. This is not to say I am right and they are wrong. But I am of the belief that if it smells funny I should stay away. This smells funny to me.
Finally there are multiple mines on the horizon. While the demand for rare earths is likely to increase, so too will the supply. We are only a few years away from mines in Greenland(2016) and other parts of the world producing Heavy REE. I am no macro expert though and certainly don't try to be one, this is simply an afterthought.
No position, long or short.
The rarity of sales are surprising when we consider the price appreciation of rare earths. What is management waiting for? Another parabolic price increase in rare earths? In any parabolic curve one risks tremendous downside with an extended wait. Ask all the oil speculators who waited for $200/bbl oil in 2008. Still waiting.
So with that said, the starting point is knowing whether or not Dacha is a $1.00 dollar selling for $0.50 (or $0.94 of assets per share selling for $0.38/share 5/11/2012).
With thinly traded assets I believe acting as the end user is prudent. I always remembered Michael Burry's Mortgage CDS trade. Essentially, the quoted price didn't reflect reality. So what would I pay for each rare earth if I was an end user and needed it?
Dysprosium oxide: Currently dysprosium oxide is being held with a value of $16.8M. They have 15,000 kg giving a spot price of $1,118/kg. It is listed at 3N purity (99.9%). The exact purity is questionable though as it was listed at 4N in September.
I was able to get a couple of bulk quotes of dysprosium oxide.
"We can offer Dysprosium oxide, 99.99% (Dy2O3/REO), $1390/kg" -a US based company
I got an offer from the same company for 99.9% Dy2O3 for $1190/kg.
aliexpress gives a quote of $1,140/kg for a purity that isn't quite known (2N-3N5).
When everything is all said and done, channel checking showed dysprosium oxide is likely held at fair value.
Terbium oxide: Currently terbium oxide is being held on the books of Dacha's balance sheet at $29.1M. They have 14,000 kg giving a spot price of $2,075/kg. It is listed at 4N+ purity (99.99%).
"Terbium Oxide Powder TbO, 4N Purity 906 grams @ $5.10/gram = $4,620.60"-US Based company
"For your information, our current price for Terbium Oxide 99.99% 5kg is at USD5,150.00/kg"-Chinese company
The US company above told me that they couldn't offer larger quantities of terbium, they only sell by the gram. Which is interesting because another company also sells terbium oxide 4N by the gram. When I went to check out, 25g was only $40 ($1600/kg).
Finally a fourth, US domiciled, company offered large quantities of terbium oxide for $1,635/kg. Same purity Dacha has, 4 weeks to delivery.
This should be pretty easy to figure out who I would order material from.
I understand that terbium is not quoted often. But if I was a large end user of terbium oxide (the typical customer of Dacha) I would probably call around. After calling around, I would purchase terbium from the cheapest and most reliable terbium provider in a country with good business practice.
I may be biased though. I had several occasions in my old job where after ordering from Chinese companies we realized "greater than 99% pure" meant a couple of % of bug legs. If I can get a cheaper product from the US it's not even a question of who I would order with.
As far as DyFe goes I had difficulty securing quotes. I can't say one way or another if the value of the inventory is high or low. Using historical Shanghai Metals Market data for dysprosium iron alloy (2,650,000 RMB/MT or ~$420/kg with conversion rates today) suggests they held it higher than what it was actually worth(recorded at $525/kg on Dacha's balance sheet as of 3/10/2011). Unsurprisingly there was a 20% premium baked into this (similar to the other metals). Perhaps this is due to the Chinese export tax. But obviously this can't be completely true since I was able to source material in the US.
DyFe, Dy oxide, and terbium oxide make up 90% of the inventory. I believe that the prices given by Dacha are somewhat optimistic. We'll need to estimate book value if this is simply asset arbitrage. As of 4/30/2012 they had metals and cash worth $88.6M ($0.94/share, 94.3M shares fully diluted). They have liabilities of $1.6M. So book value as stated is ~$87M as of the linked May 3rd release.
Let us exercise the thought that the metals inventory may be bought at lower prices. We'll also use updated inventory figure(5/11/2012, REE prices are declining). If we lop off 20% for the DyFe inventory (held at $17.1M) and terbium (held at $29.1M) we find a "conservative" value of $36.96M (46.2*80%). Add back $23.5M (the other metals), $7.3M for cash and subtract $1.6M for total liabilities and we arrive at a book value of $58.3M.
I discarded all other assets as they were small and consisted primarily of a loan payable from Forbes and Manhattan Co, which has with no revenues or assets. In their 2010 annual report there's ample evidence of poor prior investments. I believe their acquisitions of rare earth metals proves that even a blind chicken gets feed occasionally.
Conclusion
There are simply too many moving parts to consider this a simple investment. While the simpleton in me says this is an asset play there are big hurdles to overcome.
First, management lacks discipline and seems to be using this as a personal vehicle. The Forbes and Manhattan Loan is just one example. The rallying cry is that the Chairman is a significant owner.
Well, so what? He also has a directorship with more than 20 companies(Dacha 2010 Annual Report). If this fails he'll just move on to the next company, where I'm sure he has a plethora of options. Head's he wins, tails we lose.
Their history is nothing spectacular and I have little reason to believe in their leadership. This has been well documented by other bloggers.
Second, my research shows that I can get some metals at lower prices. Chinese restrictions or not, I had no problem getting terbium, their largest stockpile, at lower prices. This is not to say I am right and they are wrong. But I am of the belief that if it smells funny I should stay away. This smells funny to me.
Finally there are multiple mines on the horizon. While the demand for rare earths is likely to increase, so too will the supply. We are only a few years away from mines in Greenland(2016) and other parts of the world producing Heavy REE. I am no macro expert though and certainly don't try to be one, this is simply an afterthought.
No position, long or short.
Tuesday, April 24, 2012
Sandstorm Metals & Energy (TSE:SND)
I just got done reading "Running Money" by Andy Kessler, fantastic read. Made me really think about the industrial revolution and the flow of capital.
One of the key takeaways was the American transformation from manufacturing to service/post-industrial(the patent age?). Essentially we capitalized on the rest of the world's desire to escape agrarian society. We gave them the means via thinking, designing, and innovating things for them to build. It can slide away just as quickly as it came.
While not based in intellectual property Sandstorm (SND) displays many of the characteristics held by these companies. They are the only player (that I found) in this capital light, high return business. This time though we are not betting on the success of a microchip or an erection pill. This time we are betting on commodities and capital allocators.
Company:
Sandstorm is a Canadian firm that provides late stage financing to natural resource players. By providing capital with very low interest rates (or none at all) SND lets these fields/mines hit a point of production. This is done without the debt that can so often cripple these mines, or the equity that can destroy shareholder value.
In exchange for this financing, SND purchases the underlying commodity at a price defined in the streaming agreement. They then turn around an unload it on the market collecting the spread between the contracted price and spot market price. This is the same model that Silver Wheaton (SLW) used and it worked out OK for investors (~800% returns in 7 years for the common equity).
Sandstorm was spun off from Sandstorm Gold, a company run by the same group that runs Sandstorm Metals & Energy.
Properties/Contracts:
I am not going to go through every scenario for pricing as I feel that it isn't necessary, plus it entails a slew of speculation. Since their costs remain set by the initial contract, we can abide by one simple rule: if commodities go up so will profits with little incremental cost.
Thunderbird
Gordon Creek, a gas field located next to Drunkards Wash in Utah. Drunkards Wash is a huge gas field that is absolutely fascinating to read about. Seriously. It has amazing geographic features and Gordon Creek shares similar attributes. They have paid $25M for the rights to purchase 35% of the gas produced at $1/mcf. The first wells are scheduled to come online in early 2012 and full production is scheduled by 2014. Management estimates that this will produce after tax operating profit of $5M in 2013 and $8-10M in 2014 based on $3.50/mcf natural gas.
Donner Metals
Bracemac-Mcleod mine in Quebec. For $20M SND received the right to buy 17.5% of copper produced at the mine for $0.80/lb if copper is more than $2.75/lb or $0.55/lb should copper fall below $2.75/lb. Production is expected to start in late 2012 early 2013. Management estimates that Donner will generate ~$2M in operating profit in 2013 and ~$5M in 2014 if copper is $3.00/lb.
Terrex Energy
Two Creek and Strathmore projects. They purchased the rights to buy 15% of the oil from Terrex for $15/bbl. Management estimates that if oil is $80/bbl than Terrex will generate $1-2M in operating profit in 2013 and similar amounts in 2013.
NovaDX
Coal mining operations in Alabama and Tennessee. For $30M they purchased the rights to buy 25% of production from both mines for several years. Their share decreases to 16% after several years. They are able to buy coal at $75/ton the whole time. Management estimates that if metallurgical coal costs $160/ton and thermal coal costs $70/ton operating profit will be ~$4M in 2013 and ~$7M in 2014.
Surge Capital helped connect NovaDX and Sandstorm and received a finders fee and shares.
Royal Coal
Coal mine in Kentucky. They have shut down and the investment was written off. To say this was a mess is putting it lightly. To make a complex story more confusing, NovaDX invested in Ikerd Coal Company. Ikerd Coal Company turned out to be a total failure and NovaDX suffered. Six weeks after the settlement Royal Coal went belly up. An embarrassment for NovaDX and more importantly Sandstorm. Royal Coal, like most mines I'm sure, was full of hope and endless riches.
Management
Nolan Watson's background can be seen in his Wikipedia page. The article has been revised numerous times by "Denvyboy." While it is only speculation, there seems to be a faint familiarity between the editors user name and Denver Harris, IR Manager at Sandstorm.
There is plenty of promotion for the company via Youtube videos, interviews with small podcast reporters, and individual investors. The company promoted stuff shouldn't be too surprising since the board and management has several people who worked in IR or on the sell-side.
There are no mining experts on the board or in management that I saw. It mostly consists of investment bankers. I personally would want to see a few people with a deep expertise of mines not just of investing. Overall I don't have a firm opinion one way or another of management.
Margin of Safety
Each streaming deal carries along with it cash flow guarantee. According to the SND presentation all cash flow guarantees and cash on the book roughly equal the market cap today (~$125M). But how guaranteed are those promises from the various resource collectors?
Royal Coal offers us some indication as to the value of these guarantees. Given that they have gone under the only question now is: how much is Sandstorm getting back?
The answer right now is: I don't know (and I've yet to find anyone who does). These streaming agreements are a mix between debt and equity. Senior secured like debt, upside like equity. For investors in mining though, all that matters is a hole in the ground produces more cash than it loses. While these guarantees are great, they really only apply if the mine is making enough money to pay them. The margin of safety exists in the mines.
In the Q4 CC Nolan highlighted that they now have a large tax benefit due to the Royal Coal write-off. I would rather have cash from the original agreement. When asked about changes made to the due diligence process going forward answers have been vague and in my opinion, unsatisfactory.
Are the individual properties worth investing in?
Luckily all of the mines and fields that Sandstorm has invested in are traded on Canadian exchanges, so information is plentiful. The NovaDX mine has generated quite a bit of optimism from one blogger, so let's examine them a little.
NovaDX In-depth
All sources with (pg --) are from the Rex Mine Technical Report.
NovaDX has two properties that are interesting to Sandstorm investors, Rex #1 and Rosa. From the SND presentation, Rex #1 should produce 500k tons/year and Rosa should produce 150K tons/year. Rosa is currently in commercial production and generated $1.6M in revenues in Q4 2011, $233K going to SND(pg 28 Dec 31 2011 Financial Statement). Rex #1 is under construction and should be up by Q3 2013.
The company itself is cash flow negative and has $3M cash to $3.7M in debt. They will probably need to issue more debt, equity, or streaming agreements soon due to cash burn and capital expenditures required before Rex #1 is fully operational. With SG&A of $1.2M and COGS of $3.8M in Q4 2011 they've got a ways to go before becoming profitable.
While the blogger above believes that metallurgical coal has restricted supply and steady long term contracts, this mine needs to first be cash flow positive to benefit from either scenario.
Another hurdle is getting the Stinking Creek Plant (what a name) processing facility up and running. Right now they are selling coal at a discount ($90/ton, pg 69) to a 3rd party metallurgical alloy and specialty coal producer (pg 36). The plant is scheduled to be operational in Q3 2012 (pg 67) and the mine should be at full production in Q3 of 2013(pg 64).
SND reported Rex 2P reserves of 32M tons (slide 10). The most recent technical report from NovaDX lists 2P reserves at 11.2M tons (pg 18). The new report was much more conservative and the SND IR presentation hasn't been updated yet. A 65% reduction in reserves is a lot and while doesn't take away from the potential investment(on a 10 year time span), it certainly takes away from the mentioned blogger's extremely long life of mine assessment.
Finally, Neil MacDonald is CEO and Robert Payne is COO. They both resided over the acquisition of Ikerd's Flatwood property, which was done with Sandstorms knowledge. This did not end well. They then got shares and ownership to Royal Coal, which as explained above, did not go well either. There is a lot of money and pride riding on the success of the Rex and Rosa mines.
With cash costs of ~$80/ton(pg 73), selling prices of $90/ton and huge capital expenditures, it's hard for me to get comfortable with NovaDX. Factor in their history of investments and it's even less appealing. Right now with my limited knowledge I put NovaDX in the "too hard" pile. This could change upon new information regarding the processing plant, cash flows, and consistently less deleterious investments.
Conclusion:
Sandstorm offers a compelling story. And for me right now that's about it.
The bull thesis hinges on Nolan Watson and his team executing. I would like to understand his successes and failures at SLW better before declaring him a visionary. This is 100% a bet on management and I lack conviction in them right now. For reasons unknown to me, Libra Advisors is selling large blocks of shares at a rapid clip.
In two years the company might be generating $25M in FCF. Relative to today's EV gives SND a FCF/EV yield of ~29% (MC of 125M minus 40M cash on the books). This FCF figure depends on the commodity prices outlined by SND here. Some are higher now(oil), some are lower now(natural gas). If we assume that cash will get spent in a year or two (Nolan said they were starting to look for new streaming agreements in the Q4 CC) than EV=MC. In that case 2014's FCF of ~$25M gives us a 20% yield. Good, but not great given the uncertainty of mining.
I will follow up with some other posts that try to examine the individual value of the Donner, Terrex, and Thunderbird Streams. This investment as a whole sits in the "too hard" pile currently. It may be cheap, but with a few more Royal Coal's, it may be bankrupt. Being a sucker for predictable cash flows I will keep on researching. This might very well make a phenomenal investment, but right now it's not so clear to me.
One of the key takeaways was the American transformation from manufacturing to service/post-industrial(the patent age?). Essentially we capitalized on the rest of the world's desire to escape agrarian society. We gave them the means via thinking, designing, and innovating things for them to build. It can slide away just as quickly as it came.
While not based in intellectual property Sandstorm (SND) displays many of the characteristics held by these companies. They are the only player (that I found) in this capital light, high return business. This time though we are not betting on the success of a microchip or an erection pill. This time we are betting on commodities and capital allocators.
Company:
Sandstorm is a Canadian firm that provides late stage financing to natural resource players. By providing capital with very low interest rates (or none at all) SND lets these fields/mines hit a point of production. This is done without the debt that can so often cripple these mines, or the equity that can destroy shareholder value.
In exchange for this financing, SND purchases the underlying commodity at a price defined in the streaming agreement. They then turn around an unload it on the market collecting the spread between the contracted price and spot market price. This is the same model that Silver Wheaton (SLW) used and it worked out OK for investors (~800% returns in 7 years for the common equity).
Sandstorm was spun off from Sandstorm Gold, a company run by the same group that runs Sandstorm Metals & Energy.
Properties/Contracts:
I am not going to go through every scenario for pricing as I feel that it isn't necessary, plus it entails a slew of speculation. Since their costs remain set by the initial contract, we can abide by one simple rule: if commodities go up so will profits with little incremental cost.
Thunderbird
Gordon Creek, a gas field located next to Drunkards Wash in Utah. Drunkards Wash is a huge gas field that is absolutely fascinating to read about. Seriously. It has amazing geographic features and Gordon Creek shares similar attributes. They have paid $25M for the rights to purchase 35% of the gas produced at $1/mcf. The first wells are scheduled to come online in early 2012 and full production is scheduled by 2014. Management estimates that this will produce after tax operating profit of $5M in 2013 and $8-10M in 2014 based on $3.50/mcf natural gas.
Donner Metals
Bracemac-Mcleod mine in Quebec. For $20M SND received the right to buy 17.5% of copper produced at the mine for $0.80/lb if copper is more than $2.75/lb or $0.55/lb should copper fall below $2.75/lb. Production is expected to start in late 2012 early 2013. Management estimates that Donner will generate ~$2M in operating profit in 2013 and ~$5M in 2014 if copper is $3.00/lb.
Terrex Energy
Two Creek and Strathmore projects. They purchased the rights to buy 15% of the oil from Terrex for $15/bbl. Management estimates that if oil is $80/bbl than Terrex will generate $1-2M in operating profit in 2013 and similar amounts in 2013.
NovaDX
Coal mining operations in Alabama and Tennessee. For $30M they purchased the rights to buy 25% of production from both mines for several years. Their share decreases to 16% after several years. They are able to buy coal at $75/ton the whole time. Management estimates that if metallurgical coal costs $160/ton and thermal coal costs $70/ton operating profit will be ~$4M in 2013 and ~$7M in 2014.
Surge Capital helped connect NovaDX and Sandstorm and received a finders fee and shares.
Royal Coal
Coal mine in Kentucky. They have shut down and the investment was written off. To say this was a mess is putting it lightly. To make a complex story more confusing, NovaDX invested in Ikerd Coal Company. Ikerd Coal Company turned out to be a total failure and NovaDX suffered. Six weeks after the settlement Royal Coal went belly up. An embarrassment for NovaDX and more importantly Sandstorm. Royal Coal, like most mines I'm sure, was full of hope and endless riches.
Management
Nolan Watson's background can be seen in his Wikipedia page. The article has been revised numerous times by "Denvyboy." While it is only speculation, there seems to be a faint familiarity between the editors user name and Denver Harris, IR Manager at Sandstorm.
There is plenty of promotion for the company via Youtube videos, interviews with small podcast reporters, and individual investors. The company promoted stuff shouldn't be too surprising since the board and management has several people who worked in IR or on the sell-side.
There are no mining experts on the board or in management that I saw. It mostly consists of investment bankers. I personally would want to see a few people with a deep expertise of mines not just of investing. Overall I don't have a firm opinion one way or another of management.
Margin of Safety
Each streaming deal carries along with it cash flow guarantee. According to the SND presentation all cash flow guarantees and cash on the book roughly equal the market cap today (~$125M). But how guaranteed are those promises from the various resource collectors?
Royal Coal offers us some indication as to the value of these guarantees. Given that they have gone under the only question now is: how much is Sandstorm getting back?
The answer right now is: I don't know (and I've yet to find anyone who does). These streaming agreements are a mix between debt and equity. Senior secured like debt, upside like equity. For investors in mining though, all that matters is a hole in the ground produces more cash than it loses. While these guarantees are great, they really only apply if the mine is making enough money to pay them. The margin of safety exists in the mines.
In the Q4 CC Nolan highlighted that they now have a large tax benefit due to the Royal Coal write-off. I would rather have cash from the original agreement. When asked about changes made to the due diligence process going forward answers have been vague and in my opinion, unsatisfactory.
Are the individual properties worth investing in?
Luckily all of the mines and fields that Sandstorm has invested in are traded on Canadian exchanges, so information is plentiful. The NovaDX mine has generated quite a bit of optimism from one blogger, so let's examine them a little.
NovaDX In-depth
All sources with (pg --) are from the Rex Mine Technical Report.
NovaDX has two properties that are interesting to Sandstorm investors, Rex #1 and Rosa. From the SND presentation, Rex #1 should produce 500k tons/year and Rosa should produce 150K tons/year. Rosa is currently in commercial production and generated $1.6M in revenues in Q4 2011, $233K going to SND(pg 28 Dec 31 2011 Financial Statement). Rex #1 is under construction and should be up by Q3 2013.
The company itself is cash flow negative and has $3M cash to $3.7M in debt. They will probably need to issue more debt, equity, or streaming agreements soon due to cash burn and capital expenditures required before Rex #1 is fully operational. With SG&A of $1.2M and COGS of $3.8M in Q4 2011 they've got a ways to go before becoming profitable.
While the blogger above believes that metallurgical coal has restricted supply and steady long term contracts, this mine needs to first be cash flow positive to benefit from either scenario.
Another hurdle is getting the Stinking Creek Plant (what a name) processing facility up and running. Right now they are selling coal at a discount ($90/ton, pg 69) to a 3rd party metallurgical alloy and specialty coal producer (pg 36). The plant is scheduled to be operational in Q3 2012 (pg 67) and the mine should be at full production in Q3 of 2013(pg 64).
SND reported Rex 2P reserves of 32M tons (slide 10). The most recent technical report from NovaDX lists 2P reserves at 11.2M tons (pg 18). The new report was much more conservative and the SND IR presentation hasn't been updated yet. A 65% reduction in reserves is a lot and while doesn't take away from the potential investment(on a 10 year time span), it certainly takes away from the mentioned blogger's extremely long life of mine assessment.
Finally, Neil MacDonald is CEO and Robert Payne is COO. They both resided over the acquisition of Ikerd's Flatwood property, which was done with Sandstorms knowledge. This did not end well. They then got shares and ownership to Royal Coal, which as explained above, did not go well either. There is a lot of money and pride riding on the success of the Rex and Rosa mines.
With cash costs of ~$80/ton(pg 73), selling prices of $90/ton and huge capital expenditures, it's hard for me to get comfortable with NovaDX. Factor in their history of investments and it's even less appealing. Right now with my limited knowledge I put NovaDX in the "too hard" pile. This could change upon new information regarding the processing plant, cash flows, and consistently less deleterious investments.
Conclusion:
Sandstorm offers a compelling story. And for me right now that's about it.
The bull thesis hinges on Nolan Watson and his team executing. I would like to understand his successes and failures at SLW better before declaring him a visionary. This is 100% a bet on management and I lack conviction in them right now. For reasons unknown to me, Libra Advisors is selling large blocks of shares at a rapid clip.
In two years the company might be generating $25M in FCF. Relative to today's EV gives SND a FCF/EV yield of ~29% (MC of 125M minus 40M cash on the books). This FCF figure depends on the commodity prices outlined by SND here. Some are higher now(oil), some are lower now(natural gas). If we assume that cash will get spent in a year or two (Nolan said they were starting to look for new streaming agreements in the Q4 CC) than EV=MC. In that case 2014's FCF of ~$25M gives us a 20% yield. Good, but not great given the uncertainty of mining.
I will follow up with some other posts that try to examine the individual value of the Donner, Terrex, and Thunderbird Streams. This investment as a whole sits in the "too hard" pile currently. It may be cheap, but with a few more Royal Coal's, it may be bankrupt. Being a sucker for predictable cash flows I will keep on researching. This might very well make a phenomenal investment, but right now it's not so clear to me.
Saturday, April 7, 2012
Niska Gas Storage NKA
Business:
Niska is the largest independent natural gas storage companies in North America. Using old salt mines Niska stores natural gas in four areas.
AECO: Two fields located in Canada in old hydrocarbon reserves. The two fields have a combined 89 wells and hold 150 Bcf.
Wild Goose: Located near Sacramento, it's an old salt mine that has 15 wells and can store 35 Bcf. They are in the process of expanding both the size of the well(adding another 15 Bcf), and also increasing the injection/withdrawal speeds (up to 0.65 Bcf/1.2 Bcf respectively).
Salt Plains: Located near Oklahoma City, there is 13 Bcf of capacity and 30 wells.
NGPL: Gulf coast areas, 8.5 Bcf of capacity.
They have three different means to make money, long term storage, short term storage and optimization. LT gives them predictability with lower returns, $1.03/MMcf in 2011. ST commanded prices of $1.61/MMcf in 2011. Finally their optimization program attempts to use excess capacity to exploit seasonal spreads. This has the potential to be their cash cow, contributing 2.61/MMcf and 36% of the realized revenue despite only taking up 15% of their capacity in 2011.
Thesis:
This is a different angle to the natural gas play, a mid-stream player. If natural gas will ever become a great base load power supply, large amounts of storage will be required. While no expert, the use of LNG seems counter intuitive due to large energy demands and structural needs.
There are also multiple contrarian bets placed within this. First, the glut of natural gas has to go somewhere and storage will be necessary. Second, while volatility has dropped (and thus spreads to Niska have dropped), could it spike again? The hope here is to understand how profitable Niska is, how capable management is, and determine the probability that they will make money for the next five years.
Will volatility return?
This is difficult to understand. From PNG's 10K(another NG storage company):
"While there are a variety of factors that have contributed to these softer market conditions, we believe the key drivers are (i) relatively flat natural gas consumption over the last year and projected flat consumption for the next several years, (ii) increased natural gas supplies due to production from shale resources, (iii) net increases in storage capacity, and (iv) lower basis differentials due to expansion of natural gas transportation infrastructure in the U.S. over the last five years."
Here is a company that like NKA wants to see spreads return. There are several problems though. I think natural gas is the future, just not right now. Maybe four or five years from now, but not now and demand reflects that (having only increased by a little over 12% since 2001-pg 10 PNG 10K).
This is really a race to the bottom. Niska has increased gas storage, which creates a larger gas reserve, which lowers spreads, which impacts the profitability of Niska (and PNG). While I don't know the future of natural gas volatility I would not want to bet that spreads will return to 2007 levels (up to $4.75/MMBtu).
How capable is management?
Simon Dupere is fairly new, having only been CEO since July of 2011 his track record is unknown. In August of 2011 he believed that spreads were at their lowest, effectively calling a bottom, a brave call for the new CEO. Eight months later, with the benefit of hindsight, we notice he may have been a wee bit early.
Second, they are allowing Carlyle/Riverstone (parent fund) to reinvest their distributions as common units. This totals $18M every quarter. They have used some of the money that was reinvested to pay off their Senior Notes ($659M outstanding as of 2/2/2012). This was done in Q1 of 2011 at a predetermined price of $16/share. At that price the money saved on interest was equal to the money spent on distributions.
With share prices significantly lower now (mid 9's now), a $0.35 quarterly distribution is a 50% hike in cash flows out compared to senior notes. Right pocket left pocket can work when it's zero sum. But when the left pocket is 50% more expensive, not so good.
I have not seen whether or not they continued this program. The last two quarters debt paydown has been through inventory management. While it may turn out to be prudent it could also be the equivalent of burning the furniture to heat the house.
Finally, can they stay profitable?
Probably yes, but I can't grasp how much and for how long. Spreads are low, really low by historical standards, but NKA will be making money on ST and LT contracts. While less profitable they do provide consistency. I have little to add here unfortunately. Inventory management has aided profitability too, this is only supposed to continue for another year.
Conclusion:
It seems like a race for the bottom. Couple that with the leverage (which was downgraded recently) and unproven management I fear being snagged by a falling knife.
Adjusted EBITDA is estimated to be $125M for 2012, this seems optimistic considering managements track record of forecasts. Backing out interest (~$57M depending on further payments) and maintenance CapEx ($3M) I estimate FCF to be ~$65M or $0.95/share. They have been spending millions on expanding their facilities so true maintenance CapEx is open to debate. Spending more just to keep up needs to be considered a true cost of business. Thus CapEx figures will be substantially higher if the future includes never ending storage expansion.
At 10X FCF this seems overvalued. The distribution will need to be cut, or debt will have to be issued, and with the recent downgrade it's unlikely they'll secure debt at 8.75%. I'll let the yield pigs have it for now.
Niska is the largest independent natural gas storage companies in North America. Using old salt mines Niska stores natural gas in four areas.
AECO: Two fields located in Canada in old hydrocarbon reserves. The two fields have a combined 89 wells and hold 150 Bcf.
Wild Goose: Located near Sacramento, it's an old salt mine that has 15 wells and can store 35 Bcf. They are in the process of expanding both the size of the well(adding another 15 Bcf), and also increasing the injection/withdrawal speeds (up to 0.65 Bcf/1.2 Bcf respectively).
Salt Plains: Located near Oklahoma City, there is 13 Bcf of capacity and 30 wells.
NGPL: Gulf coast areas, 8.5 Bcf of capacity.
They have three different means to make money, long term storage, short term storage and optimization. LT gives them predictability with lower returns, $1.03/MMcf in 2011. ST commanded prices of $1.61/MMcf in 2011. Finally their optimization program attempts to use excess capacity to exploit seasonal spreads. This has the potential to be their cash cow, contributing 2.61/MMcf and 36% of the realized revenue despite only taking up 15% of their capacity in 2011.
Thesis:
This is a different angle to the natural gas play, a mid-stream player. If natural gas will ever become a great base load power supply, large amounts of storage will be required. While no expert, the use of LNG seems counter intuitive due to large energy demands and structural needs.
There are also multiple contrarian bets placed within this. First, the glut of natural gas has to go somewhere and storage will be necessary. Second, while volatility has dropped (and thus spreads to Niska have dropped), could it spike again? The hope here is to understand how profitable Niska is, how capable management is, and determine the probability that they will make money for the next five years.
Will volatility return?
This is difficult to understand. From PNG's 10K(another NG storage company):
"While there are a variety of factors that have contributed to these softer market conditions, we believe the key drivers are (i) relatively flat natural gas consumption over the last year and projected flat consumption for the next several years, (ii) increased natural gas supplies due to production from shale resources, (iii) net increases in storage capacity, and (iv) lower basis differentials due to expansion of natural gas transportation infrastructure in the U.S. over the last five years."
Here is a company that like NKA wants to see spreads return. There are several problems though. I think natural gas is the future, just not right now. Maybe four or five years from now, but not now and demand reflects that (having only increased by a little over 12% since 2001-pg 10 PNG 10K).
This is really a race to the bottom. Niska has increased gas storage, which creates a larger gas reserve, which lowers spreads, which impacts the profitability of Niska (and PNG). While I don't know the future of natural gas volatility I would not want to bet that spreads will return to 2007 levels (up to $4.75/MMBtu).
How capable is management?
Simon Dupere is fairly new, having only been CEO since July of 2011 his track record is unknown. In August of 2011 he believed that spreads were at their lowest, effectively calling a bottom, a brave call for the new CEO. Eight months later, with the benefit of hindsight, we notice he may have been a wee bit early.
Second, they are allowing Carlyle/Riverstone (parent fund) to reinvest their distributions as common units. This totals $18M every quarter. They have used some of the money that was reinvested to pay off their Senior Notes ($659M outstanding as of 2/2/2012). This was done in Q1 of 2011 at a predetermined price of $16/share. At that price the money saved on interest was equal to the money spent on distributions.
With share prices significantly lower now (mid 9's now), a $0.35 quarterly distribution is a 50% hike in cash flows out compared to senior notes. Right pocket left pocket can work when it's zero sum. But when the left pocket is 50% more expensive, not so good.
I have not seen whether or not they continued this program. The last two quarters debt paydown has been through inventory management. While it may turn out to be prudent it could also be the equivalent of burning the furniture to heat the house.
Finally, can they stay profitable?
Probably yes, but I can't grasp how much and for how long. Spreads are low, really low by historical standards, but NKA will be making money on ST and LT contracts. While less profitable they do provide consistency. I have little to add here unfortunately. Inventory management has aided profitability too, this is only supposed to continue for another year.
Conclusion:
It seems like a race for the bottom. Couple that with the leverage (which was downgraded recently) and unproven management I fear being snagged by a falling knife.
Adjusted EBITDA is estimated to be $125M for 2012, this seems optimistic considering managements track record of forecasts. Backing out interest (~$57M depending on further payments) and maintenance CapEx ($3M) I estimate FCF to be ~$65M or $0.95/share. They have been spending millions on expanding their facilities so true maintenance CapEx is open to debate. Spending more just to keep up needs to be considered a true cost of business. Thus CapEx figures will be substantially higher if the future includes never ending storage expansion.
At 10X FCF this seems overvalued. The distribution will need to be cut, or debt will have to be issued, and with the recent downgrade it's unlikely they'll secure debt at 8.75%. I'll let the yield pigs have it for now.
Wednesday, March 28, 2012
Atlas Resource Partners (ARP)
Natural gas prices are low, MLP yields are high. Throw in a spin-off and you get Atlas Resource partners.
Background:
Atlas Energy (ATLS) is a MLP with two subsidiaries, Atlas Pipeline (APL) and the newly spun off Atlas Resource Partners. The old Atlas Energy MLP was sold to Chevron in November of 2011 for 3.2B in cash. The company is engaged in US natural gas and oil plays.
ARP was spun off March 15, 2012. ATLS retained 20.96M common units, 2% general partner interest and all incentive rights. They have over 8,600 wells operating currently and ARP recently bought 277 bcfe of proven reserves from Carrizo (CRZO) for $190M. They expect 2013 pro-forma distributions to be $2.25-2.40 representing a yield around 8% at today's share prices.
Properties:
Currently ARP has 8,500 drilled wells in Appalachia that produce ~30Mmcf/d, 150 wells in Indiana, 450 wells in Tennessee, and hopes of drilling over 200 wells in Colorado. The recent Carrizo acquisition gives them access to an additional 198 wells and 277 Bcfe of reserves. Carrizo sold these properties to pay off revolving debt and to fund expenditures in their Eagle Ford play. It also sounds like they wanted to focus more on liquids. As many E&P companies are.
While I can only speculate, it seems that they did get a good deal. At $4,219 per Mcfed ($23,204 per BOE/d) and 0.69/Mcfe proven reserves this reflects favorably compared to other public companies and previous transactions. As a comparison one can buy Gale Force Petroleum at outright at 11M and get 275 BOE/d, with plans of getting 350 soon. While obviously not a perfect comparison for multiple reasons it works out to $40,000/BOE/d.
Management:
Jonathan Cohen is the Chairman of the Board and Edward Cohen is their CEO. The father and son team has been in the oil industry for awhile and did quite well with old Atlas. From the time of the IPO to the acquisition shares grew over 800%. I loved Edward's quote from CNBC just a few weeks ago "the people who are busily selling, we are busily buying. When the blood is running in the street that's a good time to be buying." I'm not sure there's blood in the streets due to low natural gas prices, but he is in Texas, so who knows.
COO is Matthew Jones. He too has been with Atlas for since the IPO, CFO since 2005.
Valuation:
I'm new to MLP land and thus I revert back to understanding the business, it's prospects, it's management and it's downside. Right now with natural gas in the dumps and oil sky high it seems every company is doing what is expected: dumping natural gas and spending heavily on liquid rich fields.
The lack of capital spending on natural gas will eventually catch up and Mr. Smith's invisible force will be upon us. When? I have no idea and pretty much any forecast besides "never" will probably be too soon. With the proposed EPA restrictions on more polluting coal plants, companies like Huntsman and Dow bringing production back to the US due to low natural gas prices, and other economic influences prices should recover.
Well capitalized and more importantly, well managed, natural gas companies should emerge with relative earning power if natural gas prices recover.
From their Form-10 they believe they will generate AEBITDA of $61.5M for the 12 months ending 12/2012, AEBITDA needs to be 52.9M to pay the minimum distribution. They have maintenance capex of 9.2M and interest expense of 900K, therefore FCF will be around 51M in 2012.
This was before the Carrizo acquisition and thus FCF will be higher. I'll consider distributions a reasonable proxy for FCF. With the expected distribution in 2013 2.25-2.40 we're given a FCF yield of 8.0%-8.6%.
The future predictability of their cash flows is obviously dependent on two variables, the price of the commodity and the amount of said commodity they can produce. They have hedged well, as shown in their presentation and noted in their filings. They indicate they have upside potential if prices climb. How much is up for debate, they estimate they have 90% of natural gas production hedged next year.
Conclusion:
I believe that ARP is a well managed company. Unfortunately I don't believe it is worth an investment right now. No number of models lead me to 20% returns annually. The bottom line is that this is a company selling at roughly 12X distribution, a rough estimate of FCF. While great if I wanted long term steady income, I will pass for now. I will continue to investigate small natural gas plays hoping to find the diamond in the rough. This spin-off has not created an opportunity in this case.
Background:
Atlas Energy (ATLS) is a MLP with two subsidiaries, Atlas Pipeline (APL) and the newly spun off Atlas Resource Partners. The old Atlas Energy MLP was sold to Chevron in November of 2011 for 3.2B in cash. The company is engaged in US natural gas and oil plays.
ARP was spun off March 15, 2012. ATLS retained 20.96M common units, 2% general partner interest and all incentive rights. They have over 8,600 wells operating currently and ARP recently bought 277 bcfe of proven reserves from Carrizo (CRZO) for $190M. They expect 2013 pro-forma distributions to be $2.25-2.40 representing a yield around 8% at today's share prices.
Properties:
Currently ARP has 8,500 drilled wells in Appalachia that produce ~30Mmcf/d, 150 wells in Indiana, 450 wells in Tennessee, and hopes of drilling over 200 wells in Colorado. The recent Carrizo acquisition gives them access to an additional 198 wells and 277 Bcfe of reserves. Carrizo sold these properties to pay off revolving debt and to fund expenditures in their Eagle Ford play. It also sounds like they wanted to focus more on liquids. As many E&P companies are.
While I can only speculate, it seems that they did get a good deal. At $4,219 per Mcfed ($23,204 per BOE/d) and 0.69/Mcfe proven reserves this reflects favorably compared to other public companies and previous transactions. As a comparison one can buy Gale Force Petroleum at outright at 11M and get 275 BOE/d, with plans of getting 350 soon. While obviously not a perfect comparison for multiple reasons it works out to $40,000/BOE/d.
Management:
Jonathan Cohen is the Chairman of the Board and Edward Cohen is their CEO. The father and son team has been in the oil industry for awhile and did quite well with old Atlas. From the time of the IPO to the acquisition shares grew over 800%. I loved Edward's quote from CNBC just a few weeks ago "the people who are busily selling, we are busily buying. When the blood is running in the street that's a good time to be buying." I'm not sure there's blood in the streets due to low natural gas prices, but he is in Texas, so who knows.
COO is Matthew Jones. He too has been with Atlas for since the IPO, CFO since 2005.
Valuation:
I'm new to MLP land and thus I revert back to understanding the business, it's prospects, it's management and it's downside. Right now with natural gas in the dumps and oil sky high it seems every company is doing what is expected: dumping natural gas and spending heavily on liquid rich fields.
The lack of capital spending on natural gas will eventually catch up and Mr. Smith's invisible force will be upon us. When? I have no idea and pretty much any forecast besides "never" will probably be too soon. With the proposed EPA restrictions on more polluting coal plants, companies like Huntsman and Dow bringing production back to the US due to low natural gas prices, and other economic influences prices should recover.
Well capitalized and more importantly, well managed, natural gas companies should emerge with relative earning power if natural gas prices recover.
From their Form-10 they believe they will generate AEBITDA of $61.5M for the 12 months ending 12/2012, AEBITDA needs to be 52.9M to pay the minimum distribution. They have maintenance capex of 9.2M and interest expense of 900K, therefore FCF will be around 51M in 2012.
This was before the Carrizo acquisition and thus FCF will be higher. I'll consider distributions a reasonable proxy for FCF. With the expected distribution in 2013 2.25-2.40 we're given a FCF yield of 8.0%-8.6%.
The future predictability of their cash flows is obviously dependent on two variables, the price of the commodity and the amount of said commodity they can produce. They have hedged well, as shown in their presentation and noted in their filings. They indicate they have upside potential if prices climb. How much is up for debate, they estimate they have 90% of natural gas production hedged next year.
Conclusion:
I believe that ARP is a well managed company. Unfortunately I don't believe it is worth an investment right now. No number of models lead me to 20% returns annually. The bottom line is that this is a company selling at roughly 12X distribution, a rough estimate of FCF. While great if I wanted long term steady income, I will pass for now. I will continue to investigate small natural gas plays hoping to find the diamond in the rough. This spin-off has not created an opportunity in this case.
Monday, March 12, 2012
Paulson Capital Corp (PLCC)
PLCC is a boutique broker dealer and boutique investment firm headquartered in Portland, OR. Founded several decades ago by Chester Paulson they specialize in small and nano-cap IPOs and charge commissions for brokerage trading. Mr. Paulson and his family own a majority of shares, Chester himself owns 2.11M shares (~36% of shares outstanding).
Recent Events:
The company is a net-net and would likely make Dr. Graham himself an investor as they are selling at 48% of stated net-net value. Reading through transcripts this is nothing new and they have sold below liquidation value for many years.
It was announced just a few weeks ago that the brokerage side of the company was sold to JHS Capital Advisors. Details on the sale are currently scarce and the sale price is unknown, thus offering potential market inefficiency. A few notes should be made as this is not Mr. Market acting completely irrationally prior to the announcement.
First, $5.5M of the $16.1M of total assets exist as receivables from clearing organizations. While regarded as "very liquid" and a "good place to put cash" (Q2 2008 conference call) it is likely that all of this will be going to JHS. Of course if that is true, accounts payable ($366K) will be going too.
Second, their trading and investment securities on the balance sheet consist of companies that are not very liquid (for the most part) and for the most part awful companies(from a value perspective). Of all the 13G's looked through, the largest position was in S&W Seed. As of 3/9/2012 PLCC held 420,000 shares worth about $2.486M. It is safe to say that a discount should be applied to these assets as it will be difficult to recognize them at easily trackedprices. An additional $3.9M of investments are made in 5 privately held companies. How accurately audited these are is anyone's guess.
This point shows why it is important to read the filings deeply because while most financial sites would consider this a net-net, I do not. Their investments are illiquid and hard to value, definitely not cash or cash equivalents. In my eyes the only liquid position is S&W Seed, making real net-net value around
Third, while insiders own a significant stake in the company it doesn't necessarily mean they are completely aligned with outside shareholders. Chester and his wife took home around $360K last year, their son-in-law and CEO took home $261K. This is a family operation and Chester's son, Charles, heads proprietary trading and advises the firm on market dynamics and trends. His understanding of market dynamics and trends resulted in losses in investment income and/or trading for 3 out of the past 4 years. Perhaps the firm should take a contrarian stance.
While I don't consider the pay egregious, they probably have more invested outside of the company than with the company. I have no clue if this is true or not though.
What would JHS buy them at?
This is a tough one but I believe we can come to a comfortable range of valuations that JHS went through.
We know the firm as a whole is losing money and it's pretty easy to see why. Commissions and salaries totaled $14.8M in 2011 compared to total revenue of $15.4M, $14.6M was related to commissions (the unit being sold). The company expects there to be a huge drop in employees with the remaining Paulson Co. Going through the list of people at the firm it seems likely that Chester Paulson (184K salary), Murray Smith (salary unknown), Jacqueline Paulson ($184K salary), Trent Davis ($261K salary), and Lorraine Maxfield ($116K salary) will be staying behind. JHS likely assumes that they can take all of their salaries out and will then try to get rid of duplicative overhead.
For the sake of simplicity I will take the $14.8M in commission and back out their salaries, which come to $867K. With some rounding ($67K lopped off as a margin of safety) salaries and commissions for the unit being sold will total $14M. This is relative to $14.6M of commissions generated (with around $1B in AUM that's one healthy management fee, perhaps I'll start a hedge fund in Oregon). This very simple exercise says that JHS will probably see $600K of profit just through elimination of the family salaries.
I believe this to be conservative though as I'm sure there will be several people axed in this process on both ends. JHS likely will see numerous redundancies and for a unit that generates 14M in revenue every 100K plus benefits will quickly add up. Also, JHS charges fees for their RBC platform that range from 0.5%-3%. When all is said and done we can safely say: pretty much the same as Paulson.
How much will they are willing to pay is a grey area though. Pick your chosen multiple off my conservative estimate. Do they expect to see better profits? Do they expect growth? Will there be an equal exchange for assets existing? I have no idea.
Gut level says they pay 6-10X of their expected first year profits. Therefore my ruler says 3.96-6.6M plus some small asset purchases at book price. Exactly what those are though is unknown to me. How receivables from RBC are treated is another big question mark. It isn't clear to me that these represent apples to apples receivables depending on collateral requirements.
So for a quick valuation, that I believe is conservative, we can do a sum of the parts. Their trading firm and investment side is pretty bad, I will value the business at zero and say it is only worth cash and "short term investments" which as discussed above are small caps and numerous warrants. So here goes my inputs...
Cash as is at 292K
Investment securities: 20% discount to 10K value despite the run up in equities (just to be conservative) = 6.1M
It is unclear to me what other assets will be considered part of the brokerage firm so I will value the remainder of the assets at zero (again to be conservative).
Liabilities are difficult to assign so to be conservative I will assume all liabilities stay with Paulson Co. -1.748M
I will assume JHS fought a hard battle and wants to buy the brokerage firm at 7X conservative earnings or $4.6M.
Conservative value = 292K+6.1M+4.6M-1.748M = $9.2M.
I'm sure there will be plenty of bonuses after the acquisition, so lets call it $9.0M. This compares to a market cap as of 3/9/2012 of 5.77M, 63% margin of safety based off of my conservative value. If we back out 3.9M (say the private company investments are worthless) PLCC is priced roughly fairly(9.0-3.9=5.1M).
I don't think PLCC should trade at book value. To put it bluntly, they are poor allocators of capital and there is no reason to believe that they could liquidate tomorrow and actually get book values. No position. All figures not linked from public filings.
4/17/2012: Well a very small transfer of business profits, and now the transaction is done I'm looking forward to reading the next SEC report that gives audited financials. For a total of $1.6M in cash from JHS, they'll have $1.9M in cash (at most, I'm sure there will be some congratulatory bonuses for selling a business with $14M in revenue for $1.6M...).
So going to my quick valuation we have cash of $1.9M, and equities worth around $6.1M (old data I know) and liabilities of $1.748M. I'm not sure whether or not to add back the receivables, but I think I will this time to get a high estimate. So 1.9+6.1+5.5-1.748 =11.75 (6.25M w/o receivables FWIW). Some of these liabilities will probably drop, since compensation expenses were included in the merger. Regardless it's pretty damn hard to come up with a fair value, especially a fair value that shareholders will see. Paulson is now a business with $1.3M in revenue paying salaries of at least $867K. Throw in another $200K for other general and administrative expenses and we're basically at breakeven.
Recent Events:
The company is a net-net and would likely make Dr. Graham himself an investor as they are selling at 48% of stated net-net value. Reading through transcripts this is nothing new and they have sold below liquidation value for many years.
It was announced just a few weeks ago that the brokerage side of the company was sold to JHS Capital Advisors. Details on the sale are currently scarce and the sale price is unknown, thus offering potential market inefficiency. A few notes should be made as this is not Mr. Market acting completely irrationally prior to the announcement.
First, $5.5M of the $16.1M of total assets exist as receivables from clearing organizations. While regarded as "very liquid" and a "good place to put cash" (Q2 2008 conference call) it is likely that all of this will be going to JHS. Of course if that is true, accounts payable ($366K) will be going too.
Second, their trading and investment securities on the balance sheet consist of companies that are not very liquid (for the most part) and for the most part awful companies(from a value perspective). Of all the 13G's looked through, the largest position was in S&W Seed. As of 3/9/2012 PLCC held 420,000 shares worth about $2.486M. It is safe to say that a discount should be applied to these assets as it will be difficult to recognize them at easily trackedprices. An additional $3.9M of investments are made in 5 privately held companies. How accurately audited these are is anyone's guess.
This point shows why it is important to read the filings deeply because while most financial sites would consider this a net-net, I do not. Their investments are illiquid and hard to value, definitely not cash or cash equivalents. In my eyes the only liquid position is S&W Seed, making real net-net value around
Third, while insiders own a significant stake in the company it doesn't necessarily mean they are completely aligned with outside shareholders. Chester and his wife took home around $360K last year, their son-in-law and CEO took home $261K. This is a family operation and Chester's son, Charles, heads proprietary trading and advises the firm on market dynamics and trends. His understanding of market dynamics and trends resulted in losses in investment income and/or trading for 3 out of the past 4 years. Perhaps the firm should take a contrarian stance.
While I don't consider the pay egregious, they probably have more invested outside of the company than with the company. I have no clue if this is true or not though.
What would JHS buy them at?
This is a tough one but I believe we can come to a comfortable range of valuations that JHS went through.
We know the firm as a whole is losing money and it's pretty easy to see why. Commissions and salaries totaled $14.8M in 2011 compared to total revenue of $15.4M, $14.6M was related to commissions (the unit being sold). The company expects there to be a huge drop in employees with the remaining Paulson Co. Going through the list of people at the firm it seems likely that Chester Paulson (184K salary), Murray Smith (salary unknown), Jacqueline Paulson ($184K salary), Trent Davis ($261K salary), and Lorraine Maxfield ($116K salary) will be staying behind. JHS likely assumes that they can take all of their salaries out and will then try to get rid of duplicative overhead.
For the sake of simplicity I will take the $14.8M in commission and back out their salaries, which come to $867K. With some rounding ($67K lopped off as a margin of safety) salaries and commissions for the unit being sold will total $14M. This is relative to $14.6M of commissions generated (with around $1B in AUM that's one healthy management fee, perhaps I'll start a hedge fund in Oregon). This very simple exercise says that JHS will probably see $600K of profit just through elimination of the family salaries.
I believe this to be conservative though as I'm sure there will be several people axed in this process on both ends. JHS likely will see numerous redundancies and for a unit that generates 14M in revenue every 100K plus benefits will quickly add up. Also, JHS charges fees for their RBC platform that range from 0.5%-3%. When all is said and done we can safely say: pretty much the same as Paulson.
How much will they are willing to pay is a grey area though. Pick your chosen multiple off my conservative estimate. Do they expect to see better profits? Do they expect growth? Will there be an equal exchange for assets existing? I have no idea.
Gut level says they pay 6-10X of their expected first year profits. Therefore my ruler says 3.96-6.6M plus some small asset purchases at book price. Exactly what those are though is unknown to me. How receivables from RBC are treated is another big question mark. It isn't clear to me that these represent apples to apples receivables depending on collateral requirements.
So for a quick valuation, that I believe is conservative, we can do a sum of the parts. Their trading firm and investment side is pretty bad, I will value the business at zero and say it is only worth cash and "short term investments" which as discussed above are small caps and numerous warrants. So here goes my inputs...
Cash as is at 292K
Investment securities: 20% discount to 10K value despite the run up in equities (just to be conservative) = 6.1M
It is unclear to me what other assets will be considered part of the brokerage firm so I will value the remainder of the assets at zero (again to be conservative).
Liabilities are difficult to assign so to be conservative I will assume all liabilities stay with Paulson Co. -1.748M
I will assume JHS fought a hard battle and wants to buy the brokerage firm at 7X conservative earnings or $4.6M.
Conservative value = 292K+6.1M+4.6M-1.748M = $9.2M.
I'm sure there will be plenty of bonuses after the acquisition, so lets call it $9.0M. This compares to a market cap as of 3/9/2012 of 5.77M, 63% margin of safety based off of my conservative value. If we back out 3.9M (say the private company investments are worthless) PLCC is priced roughly fairly(9.0-3.9=5.1M).
I don't think PLCC should trade at book value. To put it bluntly, they are poor allocators of capital and there is no reason to believe that they could liquidate tomorrow and actually get book values. No position. All figures not linked from public filings.
4/17/2012: Well a very small transfer of business profits, and now the transaction is done I'm looking forward to reading the next SEC report that gives audited financials. For a total of $1.6M in cash from JHS, they'll have $1.9M in cash (at most, I'm sure there will be some congratulatory bonuses for selling a business with $14M in revenue for $1.6M...).
So going to my quick valuation we have cash of $1.9M, and equities worth around $6.1M (old data I know) and liabilities of $1.748M. I'm not sure whether or not to add back the receivables, but I think I will this time to get a high estimate. So 1.9+6.1+5.5-1.748 =11.75 (6.25M w/o receivables FWIW). Some of these liabilities will probably drop, since compensation expenses were included in the merger. Regardless it's pretty damn hard to come up with a fair value, especially a fair value that shareholders will see. Paulson is now a business with $1.3M in revenue paying salaries of at least $867K. Throw in another $200K for other general and administrative expenses and we're basically at breakeven.
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