Exited Clear Leisure: still a train wreck

When I entered my position in Clear Leisure a bit more than a year ago I realized that it was a hairy situation, but I couldn’t resist buying a company at 2p/share that announced a 2p/share dividend. The dividend payment never materialized, and in the past year the stock was more often suspended for trading than not. When you have an investment that isn’t working out you are in a tough spot: you don’t want to sell at the point of maximum pessimism, but you also don’t want to hold on to a loser. Behavioral finance suggests that this is a common mistake that is made by investors but knowing this fact doesn’t really provide a solution.

I guess I didn’t sell at the point of maximum pessimism because the 52 week low is 0.51p/share and I sold yesterday at 1.30p/share for a realized loss of 35%. But you could make a good case for the fact that I should have sold a lot earlier in 2014 when it became apparent that the 2p dividend was unlikely to happen, and perhaps in the future this sale will appear ill-timed as well. But when the stock suddenly jumped yesterday on no news I thought it was a good moment to take my losses. Fundamentally the company is not a lot different than a year ago, but the potential upside will probably be diluted soon since they are planning to raise equity.

Whether or not Clear Leisure was a bad investment remains a tough question to answer. It certainly didn’t go my way, but I recognized it as a high-risk situation and you can’t determine what the probability of a favorable outcome was ex-post. I’m inclined to think that my Clear Leisure bet was a mistake, but not because of fundamental reasons related to the company.

The biggest problem is the fact that it was trading on the AIM market in London, and that market has ridiculous trading costs because it does not have an electronic order book in which your orders can be matched against other investors. You can only execute your orders against a market maker, and as a result you are forced to pay the wide bid/ask spread. This makes it very costly to change your opinion, something that is likely to happen when you invest in a hairy situation. To make things worse, I bought this position at the new Dutch broker “DeGiro” and their trading system is so crappy that you often have to e-mail their helpdesk just to get an order accepted by their system. Otherwise, I would probably have been able to exit earlier.

Train wreck

Disclosure

No position in Clear Leisure anymore

Clarke announces results of tender offer

Clarke announced the results of their second tender offer this year. Unlike the first tender offer they managed to buy back a meaningful amount of shares. In the first tender offer for CA$9.50/share they bought 3.4% of the outstanding shares while they bought 12.6% of the outstanding shares in the second tender offer for CA$10/share. The offer was oversubscribed which allowed the company to repurchase an additional 2% of the outstanding shares. Buying back your own shares at a sizable discount is an easy way to make money, and as a result of the two transactions book value per share is now 3.9% higher than at the start of the year:

The Offer was an accretive transaction for Clarke as the Shares acquired under the Offer were purchased at a substantial discount to the Company’s book value per Share. Adjusting the Company’s $12.57 book value per share at December 31, 2014 solely for the effects of the Offer and the Company’s previous substantial issuer bid that was completed on January 26, 2015 , Clarke’s pro forma book value per share at December 31, 2014 was $13.06 .

This is exactly why I like Clarke as an investment. You can win when the discount to NAV shrinks, or you can win when the company creates value by repurchasing shares at a discount.

Disclosure

Author is long Clarke

Paramount/Coeur merger/spin-off arbitrage

At the end of last year, Coeur Mining announced that it would acquire Paramount Gold & Silver in an all-stock transaction. It’s a strategic transaction that makes sense: Paramount owns silver and gold deposits in Mexico that are adjacent to Coeur’s properties. Because of this there are significant synergies that can be realized:

PZG/CDE synergies slide

The transaction is expected to close on April 17 when shareholders at both companies have to vote on the transaction. The company has obtained the required regulatory approval for this deal from the Mexican government and it doesn’t need to obtain financing. I think that this is a deal that is almost certain to go through. Usually when this is the case the spread between the two stocks is so small that there is little money to be made in the merger arb.

But this is no ordinary deal, as already hinted in the title of this post there is at the same time also a spin-off. Paramount not only owns assets in Mexico, but it also owns a gold deposit in Nevada that Coeur doesn’t want. This asset will be spun-off before the merger together with $10 million dollar in cash that Coeur will contribute to the new company. How valuable SpinCo will be is an unknown, but today you can get it almost for free and at a big discount to its future cash balance. Current Paramount shareholders will not get 100% of SpinCo, Coeur also obtains a small interest. The deal is structured as follows:

PZG/CDE deal structure

When we value SpinCo at only its cash/share value the current spread is roughly 4%. That’s in my opinion already pretty attractive, and their gold deposit is presumably worth something as well. Perhaps a hint of its value can be extracted from the price that Coeur will pay for its 4.9% interest: $1.47 million. This implies a valuation of $30 million for SpinCo or $0.1761per PZG share which would imply a spread of ~14%. While Coeur and Paramount could have structured the deal to arrive at almost any valuation I think that it is probably a pretty decent estimate of value: I bet their accountants would like to see that a related party transaction occurs at something that resembles fair value. As long as the number is in the right ballpark I’m happy.

Chris DeMuth Jr. has a more optimistic take on the valuation in this Seeking Alpha blog post. The value of the gold deposit in Nevada is very leveraged to the price of gold, and if you model a small probability of significant higher gold prices in a few years the value of the deposit increases greatly. I wouldn’t want to bet on that, but optionality is worth something.

An additional sweetener to the deal is the fact that a long PZG, short CDE position has a significant positive carry. Borrowing the CDE shares costs around 1% while you can lend your PZG shares at 35%. If you are able to fully capture the high lending fees on the PZG leg you could make an additional return of 1.4% in the 15 days that it will take before the merger closes. Capturing the full spread will be difficult for most, but it should be a nice bonus.

The high borrow fee for PZG is at the same time also a risk factor because you have to ask what the shorts know what you don’t. In this case, I think the high borrow fee can be partly explained by an inefficient lending market. Just 7.4% of the PZG shares have been sold short, and this percentage has been declining since last year. CDE has actually 12% of the float sold short, but probably because it’s a bigger and more liquid company it also has a more efficient lending market. I think it’s reassuring to know that the shorts aren’t betting against the merger. The company might not be great, but that’s to be expected when you look at an exploration stage mining company. Betting against that group was (is?) a pretty decent trade.

Disclosure

Long PZG, short CDE

Annual results: Conduril, Ming Fai, Retail Holdings & Rella

The last week of March was a busy month with several of my portfolio companies releasing their results for 2014. My biggest position is Conduril, and they released their results for 2014 yesterday. As usual the annual report is at the moment only available in Portuguese, the translated English version should follow in a couple of weeks.

Conduril

Conduril’s performance for 2014 was satisfactory, but there are a couple of clouds in the sky. Their backlog dropped from €750 million at the end of 2013 to just €450 million at the end of 2014, one of the lowest levels in years. Generating free cash flow also proved a problem in 2014. This wasn’t exactly a surprise since the company announced in their interim report that the Angolan government settled a large outstanding receivable with certificates of public debt. But even when we ignore this item we see that working capital is growing while revenues have been shrinking the past years. The good news is that the company announced that it will pay a €2/share dividend this year and that it is still dirt cheap. It’s trading at a P/E ratio of just 4.2x and of P/B ratio of just 0.6x which is a small discount to NCAV.

An updated summary of their financial performance for the past six years is provided in the table below. A large part of the positive differential between other income and other expenses is caused by foreign exchange gains. Probably repeatable for 2015 given the decline of the euro this year, but of course not sustainable in the long-term:

Historical results Conduril (2014 AR update)

Ming Fai International Holdings

Ming Fai also reported results for 2014. My thesis for the company is based on the fact that the profitability of their core business is ‘hidden’ by two loss-making divisions, but since one of these divisions has been shut down mid-2014 I expected that reported results would soon improve. Reported net income did indeed jump by 67% in 2014 while the dividend was also increased by 29%. While this is, of course, good news there was also some bad news buried in the financials. The profitability of their crown jewel, the amenity segment, decreased while losses in the retail segment only got bigger:

Segment details Ming Fai (2014AR update)

Retail Holdings

Retail Holdings also reported their 2014 results yesterday. Results for 2014 weren’t particularly impressive, but the company continues to trade at a 40% discount to NAV, announced another $1/share dividend while the long-term strategy is still to monetize the value of its assets. It’s for sure taking a long time, but we get paid to wait and intrinsic value can grow in the meantime. The chairman of the company is pretty optimistic:

I remain optimistic about 2015 and later years. I anticipate a marked improvement in Sri Lanka’s performance, reflecting accelerating economic growth, helped by lower oil prices, an improving agriculture picture, an increase in government salaries, and an uptick in consumer confidence, as well as the launch of a major new financial services initiative. In Bangladesh, a lot will depend on political developments, but the Company’s performance should improve in any case, particularly in the second half of the year, as the Company’s new refrigerator factory begins production, and other improvements now under way impact results. Pakistan and Thailand’s performance should also improve as new initiatives impact results. I expect India to continue to grow strongly. Revenue and profits in 2015 and later years will also benefit from the rollout of the new Cambodian business and from the Company’s ongoing investment in new and renovated shops and in new products, brands and services.

The holding company currently consists of the following assets:

Retail Holdings NAV (2014AR update)

What I also found interesting was the following paragraph in the annual report:

During 2014, the Company returned to equity $49,000 of the 2009 distribution, representing unclaimed distributions of non U.S. shareholders; an additional $13,000 was escheated. During 2013, the Company returned to equity $175,000 of the 2008 distribution, representing unclaimed distributions of non U.S. shareholders; an additional $3,000 was escheated.

I’m not familiar with the relevant laws in the US. I’m wondering if shareholders that don’t claim their dividends lose the right to receive them after 5 years? And what will happen if the company eventually liquidates? It appears that approximately 5% of dividends go unclaimed, and if this eventually accrues to other shareholders it could be a nice bonus?

Rella Holding

Since Rella announced that they would sell their stake in Aller and liquidate it doesn’t really matter what the latest results are. Despite that fact, the annual report did contain a couple of interesting items. The company increased the estimated liquidation proceeds from 77DKK/share to 77.5DKK/share. What I also found noteworthy is that the company renewed their share repurchase authorization. I don’t know if they are going to use it, but it would allow Rella to bet on its own liquidation. Could generate a bit of value for remaining shareholders.

Disclosure

Long Conduril, Ming Fai and Retail Holdings. No position in Rella anymore.

Interactive Brokers as a GARP investment?

Interactive Brokers isn’t your typical value stock: it’s trading near an all-time high with a P/E ratio of 44x and a P/B ratio of 2.6x. But despite that the company managed to get a spot on my research list. It’s one part curiosity simply because I’m a customer at the firm and one part because I strongly believe that Interactive Brokers is awesome. I have experience with a large number of different brokerages and not a single one comes even close to Interactive Brokers. I’m clearly not the only investor who shares that opinion since the number of customers has grown at an almost 17% CAGR since 2008:

Account growth at Interactive BrokersWhen you look at a graph like that I think it’s pretty easy to justify a lofty multiple, but before we do that we should try to understand the business and the competitive landscape a bit better.

Business model

The first thing to realize is that Interactive Brokers is, despite their awesomeness, not a broker for everybody. They target sophisticated investors who already have significant experience, are more active than average and have more money than average. What they offer are, among other things, lower fees and better trade execution. For the past twelve months, IB reported that their customers average total trading cost was 1.2 basis points of trade value compared to daily VWAP (I’m sure you know this, but it’s worth emphasizing: one basis point is one one-hundredth of one percentage point!). Other brokers don’t disclose this statistic, and presumably for good reasons since they not only charge higher fees but also execute trades at worse prices.

IB all-in trading costs

IB can offer lower costs because of their superior technology that allows them to automate many aspects of their business. Technology is also part of the reason why they are able to execute trades at better prices: their order routing is better, and they don’t sell their customers order flow to internalizers. They also pass-through exchange rebates to customers which reduces the incentive to route customer orders to exchanges with a high rebate – that the broker can pocket – at the expense of price and/or fill rate.

Another good thing about their business model is that IB attracts the most valuable customers. Most electronic brokers have to spend a significant amount of money on advertising to attract customers, and most customers that they attract are small accounts from inexperienced investors. These accounts are not very profitable (if at all) because they usually don’t generate a lot of trading commissions and they do place a heavy load on the customer support department. I couldn’t find the source, but I do remember hearing that Binck – the biggest online broker in the Netherlands – is generating more than 80% of its revenues from just 0.1% of its customers. I think that’s bad news for Binck because exactly those large and active accounts can presumably gain a lot by switching to Interactive Brokers.

The latest annual report of Binck is in my opinion worth reading because they explain their business model very well. They write the following about their weaknesses:

  • Heavy dependency on volatile transaction income and a relatively small group of very active customers for online brokerage
  • High fixed cost base (infrastructure)
  • Still not enough volume to make optimal use of economies of scale

While IB’s fixed cost base is without a doubt higher than Binck’s their strengths are basically Binck weaknesses. They do have economies of scale and because of the rapid growth in customer accounts this competitive edge is only getting bigger. At the same time, they have an offering that is especially well tailored to the most valuable customers of other brokers. Binck’s risk is Interactive Brokers opportunity.

I think that looking at revenue/employee is a useful exercise that shows the combined impact of higher automation and having active customers at IB. They are generating by far the highest revenue/employee while – based on revenues – they are just a small brokerage. The fact that Binck is lacking economies of scale also shows nicely in this table:

Broker revenue per employee comparison

While Binck ($600M market cap) is of course very small compared to TD Ameritrade ($20B), Schwab ($39B) and E-Trade ($8.0B) I actually think that they probably don’t differ that much with regards to the type of customers that they have and attract. I bet they are also making the most money from a relative small number of active accounts: accounts that can gain a lot by switching. The latest presentation of IB has a nice slide that shows that many customers are indeed price sensitive and switching from the big US brokers to IB:

Effect of IB's low margin rates

What we see here is that IB has rapidly taken a large part of the pie, and for a good reason because IB offers margin loans at rates that are a magnitude lower than the competition. Customers that use margin are presumably predominantly the more sophisticated active traders. At the same time, this data point is not good news with regards to IB’s growth prospects since it seems that they have already managed to grab decent market share in the US. Tripple IB’s size and they have 100% of this market: that’s never going to happen.

Growth prospects

Luckily for IB the market is bigger than the US. Interactive Brokers already gets ~50% of revenue from outside the US, but I suspect that that number has a lot of room to grow. A large part of the readers of this blog are from the US, and I think that they probably don’t realize how good they have it with regards to broker options. Brokers like TD Ameritrade and Fidelity might not be cheap, but at least they are somewhat reasonable and not total crap. In many European and Asian countries, there are really no solid options. You get crap trading possibilities combined with sky-high fees for everything. I think that this is driving IB’s impressive growth in Asia:

Geographic shift IB customers

How far they can continue to grow is a tough question. IB’s CEO, Thomas Peterffy, is very bullish, expecting accelerating growth in the near term and a long runway. From the Q4 results conference call, when asked about account growth:

Thomas Peterffy – Chairman and CEO
All I can tell you is that I am surprised that it’s not ramping up faster. So I think that next year will be over 20%. That’s what I think.

And from the Q3 results conference call:

Thomas Peterffy – Chairman and CEO
Well, if you really want to know my honest opinion, I think that in 10 years we could be the biggest broker in the world, and I am not kidding, because our technology is way out ahead.

One thing to realize is that a growing number of customer accounts doesn’t directly translate into profits. The first graph that I posted in this article looked pretty sweet, but when we look at the number of trades that customers make we see that growth is lower and less consistent:

IBs growth in DARTsIt makes sense that the average number of daily trades is way more volatile than the number of accounts since it depends heavily on market volatility: clients don’t trade if nothing is happening in the market. But I do think it is telling that DARTs have grown at a CAGR of 8.8% since 2008 versus an account growth rate of 16.8%. I think that many of the most active traders have already made the switch to IB years ago: a lot of the low-hanging fruit has been picked.

The second major component of IB’s income is interest income and this source of revenue is better correlated to the number of accounts since IB’s customers use roughly 30% margin as percentage of their equity. Thanks to rising markets IB’s customers have steadily increased their average equity per account. Of course, there is a risk that a new crisis can undo all these gains. In 2014 approximately 56% of brokerage revenue consisted of commissions, 36% interest income and 8% other.

Valuation

When valuing a growth stock I think it is often most useful to reverse engineer what kind of assumptions are required to justify the current market price, and see if you think those assumptions are (at the minimum) reasonable and something you can be comfortable with. Before we start with that we first need to understand IB’s corporate structure:

Corporate structure Interactive Brokers

The publicly traded stock is just a small part of the whole company, the remainder is still owned by Thomas Peterffy. The current market cap of the whole company is $13.6 billion, but this also included a market making unit with a book value of $1,036 million that consists of liquid securities. The market making unit is still generating a solid profit, but is at the same time struggling a bit in recent years because of competition from high-frequency traders. Simply valuing the market making business at book value is reasonable I think.

So that leaves us with a $12.6 billion value for the brokerage business, a segment that managed to generate $588.5 million in pretax earnings last year. IB is currently paying a tax rate of less than 10%, but as far as I understand that is caused by the fact that the company doesn’t recognize the tax payable by the IBG LLC partnership. Accounting for the fact that IB does a lot of business in foreign countries with a low tax rate, I think that using a 25% rate is reasonable.

A simplistic valuation can be made with the H-model that assumes that the initial high growth rate linearly declines in a certain number of years to a long-term growth rate. When we make the simplifying assumption that earnings are roughly equal to free cash flow we can use the following set of assumptions to arrive at a $12.6 billion valuation:

H-model valuation IB

It’s a very simple model, but I think these growth assumptions aren’t very aggressive nor is an 8% discount rate very low in today’s interest rate environment. The model also doesn’t account for operating leverage that is presumably present in IB’s business model.

Conclusion

IBKR is probably an interesting stock for people who specialize in buying growth at a reasonable price. The stock is not cheap, but you also don’t have to envision some extreme sky-is-the-limit story to justify the current price. One interesting question to ask yourself when you consider investing in IBKR: what’s your edge versus fellow investors? There are going to be a lot of smart investors who use the broker, understand their business model and know firsthand how they compare to the competition. IBKR isn’t some obscure stock that no-one knows about.

Disclosure

No position in IBKR