Argo Group announces second buy-back programme

Today Argo Group announced that it would start a second share repurchase program. The first program, in which the company managed to buy back 28.1% of the outstanding share capital, was completed in July. In the second program the company is looking to spend £2.0 million, the same amount as in the previous program. With 48.4 million shares that remain outstanding and a share price that has been steadily moving upwards this year to 16.25p this would be enough money to retire another 12.3 million shares: 25% of the share capital and 50% of the float. We’ll have to see if the company will be successful in doing that. I was very surprised at the amount of shares they managed to buy in the previous program, so perhaps they can surprise me again. Since the stock is still trading at an almost 50% discount to NAV a successful repurchase program could increase intrinsic value materially.

Disclosure

Author is long Argo Group

Fortune Industries merger arbitrage

Fortune Industries (PINK: FDVF) is a small HR outsourcing company that went through a controversial LBO a couple of years ago where management obtained a 91% stake in the company with a small tradable float remaining. Last week the company announced that the 91% stake was sold to Oasis Outsourcing. Following this transaction the acquirer plans to buyout the minority shares using a “short-form” merger where minority shareholders are being paid $0.586/share. This appears to be a reasonable deal since the majority shareholder is getting the same price, minus certain transaction fees and potential indemnity liabilities.

Fortune Industries logoI think a transaction like this has a very low risk of failing (less than 1%). For the acquirer it makes sense to buyout minority shareholders and it doesn’t require a large amount of money compared to the first transaction. No regulatory or shareholder approval is required either to consummate the transaction. The only thing that is necessary is mailing shareholders an information statement 30 days in advance. I managed to pickup a bunch of shares at an average price of $0.5572 which means a spread of 5.2%. Give them a couple of weeks to mail the information statement, add the 30 day waiting period and add some time for the money to arrive and this deal should close around the end of November or the beginning of December. Annualized that corresponds to a 30% return if we model a close on the first of December.

Disclosure

Author is long FDVF

Webco Industries: a cheap cyclical trading at 60% of NCAV

Webco Industries is a name that few people know, but at the same time it should ring a bell if you are reading the right value investing websites. The stock was discussed on OTC Adventures in 2012, OddballStocks.com in 2013 and more recently this year on Value Investors Club. Webco Industries is based near Tulsa, Oklahoma and is active as a manufacturer of various metal tubes. The company has more than a thousand employees and supplies specialty metal tubes to various industries such as oil & gas, (nuclear) power plants, (petro)chemical and automotive. A nice, but possibly biased, overview of what the company does can be found in this article. Before we start our deep dive in the financials, first a quick overview of some key metrics:

Last price (Sep 14, 2016): $51.50
Shares outstanding: (Apr 30, 2016): 812,900
Market cap: $41.9 million
P/B (mrq): 0.26x
P/NCAV (mrq): 0.61x
P/E (ttm): -29.3x
EV/EBIT (ttm): -429.7x

As visible from these stats the company is very cheap on an asset basis, while the metrics for profitability are not very meaningful since the company posted a small loss for the trailing twelve months. With Webco trading at 60% of net current asset value the company is trading below the famous 66% number that Benjamin Graham popularized as a threshold for buying cheap value stocks. It’s a stock worth investigating, but it’s clear that the profitability of the business is an aspect that needs closer scrutiny.

Financials

As is (unfortunately) common for unlisted microcaps the amount of disclosure provided in the quarterly and annual reports is limited (actually calling it a report is a bit of a stretch). But the most important information is there, and the upside is that it’s easy to get a good high-level overview of how the business has performed historically. In the graph below I have plotted the development of EPS, BV/s and NCAV/s (note that 2016 is the third quarter or the TTM) .

Webco historical EPS, BV/s and NCAV/s

As you can see Webco’s business is quite cyclical, earnings per share were as high as $31.99 in 2011 while dropping to negative $1.76 for the trailing twelve months. With the stock trading at $51 the market is obviously discounting the possibility of getting those peak earnings back anytime soon. Since the average earnings have been quite poor since 2008 I think that is the right viewpoint. In the article linked earlier the company boasts that they have achieved almost 10% growth since 1969 which I think is an okay result, but nothing more than that (and the question is what kind of metric that is, it’s probably equity and not equity/share).

Since 2008 equity has growth at a significantly slower rate of just 4.89% annually, and because the number of shares outstanding is slowly increasing as well the growth in equity/share is even lower. Shares outstanding have grown with just 0.86% per year since 2008 and as a result the growth of equity/share is just 4.00%. The difference between 4.89% and 4.00% isn’t that big on an absolute basis, but at the same time it means that management got approximately 20% of the profits of the company as share based payments while the operational performance was poor. There is not enough disclosure to know how high the base salaries were.Webco financials

One thing that should jump out from these financials is the amount of debt that the company is employing and how the amount of net debt has dropped quickly in the past three quarters from $75 million to $40 million. This is still a lot compared to the market cap of the company, but I think the amount should be manageable. Webco has a positive working capital of $115 million that presumable could be converted to cash relatively quickly in a liquidation scenario, and there is $91 million of PP&E on the balance sheet. Presumable some of this PP&E includes land and buildings that are recorded at historical cost while their value has grown through time.

Also noteworthy are the lines from the cash flow statement. As visible the company spend a lot of money in 2011 and 2012 on a new factory which in hindsight looks like a big mistake since they expanded right at the top of the cycle. The most recent years the amount of capital expenditures are a lot lower, and depreciation is actually higher than capex which is good for the cash flow generation of the business. But when we look at all the years since 2008 the net amount of free cash flow that is generated is very poor since most of the cash from operations is spend on capex. Perhaps most of it was growth capex that can still payoff when the industries that Webco serves switch to a higher gear, but for now it just looks like wasted money.

Valuation

There are multiple ways to value Webco, and the big question is what is the most relevant one. You can for example look at liquidation value, current earnings power, average historical earnings power or even the value of the company as an acquisition candidate. With the stock trading at just 60% of NCAV it’s intuitively clear that looking at liquidation value would yield a positive picture. You could even argue that in a liquidation scenario the deferred income tax liability would disappear since the company would record massive losses if all long term assets would be valued at zero (which you do when you look at just NCAV). NCAV/share plus the tax liability would give us a value of $104.75/share: a little bit more than 100% upside.

While liquidation value sounds like a conservative valuation technique I think that in this case it’s optimistic. I don’t expect that this company will liquidate anytime soon. They are proud of their long-term view, from the article linked earlier (Harmon is Marketing Director):

Harmon described, “Our mission statement can be summed up as we are a ‘forever kind of company’, and that’s the way we’ve always operated. We make decisions based upon the long term rather than what’s going to happen this quarter or next quarter.” This focus on long-term viability has driven significant investment in facilities, technology and product development.

Assuming that the company will continue operating as is seems therefore a good assumption. I think that investor in a company like this should roughly demand that they will grow their equity with 10%/year on average. This corresponds to a 10x P/E-ratio (when the amount of outstanding shares remains static). Because Webco has grown equity/share at a 4% rate since 2008 it basically means that the fair value of the company is a 0.40x P/B ratio. This is pretty cheap, but at the same time it still means we have 55% upside.

Webco valuation

Selling pressure

One factor that can possibly explain the low share price of Webco (besides the fact that it is unlisted, small and illiquid) is the fact that the Wells Fargo Small Cap Value Fund has been a consistent seller of the stock since 2015. The fund reduced their position from 81,000 shares in 2014 to 55,400 shares in 2015 and this year so far they have reduced their position with another 15,300 shares. That doesn’t sound like a lot, but for a company that has a trading volume of just a few thousand shares on most months that is a significant selling pressure. With 40,100 shares left the fund is still a big holder with a 4.9% stake in Webco, but thanks to the article on Value Investors Club trading volumes have increased and it should provide an opportunity for the fund to exit their whole stake relatively quickly.

Conclusion

Webco Industries is not a great business. Returns on equity have been low on average, the share count is slowly growing despite mediocre performance, free cash flow is low because earnings are plowed back in the company and the disclosure of relevant information to investors is poor. Despite all these factors I think that at the current price an investment in the company is warranted. With a 4% historical growth rate of equity/share you basically buy an equity yielding 15.4% at the current price.

At the same time the book value and the large amount of current assets inside the business provide a solid measure of downside protection if things take a turn for the worse. It’s hard to quantify how valuable this asset protection is, but I think it’s a pretty big deal. If a company with negligible (in)tangible and/or current assets becomes structurally unprofitable you are left with nothing at all. If it would happen with this stock you could, in theory, even make money. In reality a lot of assets would probably be used to try to turn the ship around, but even then you have a bigger possibility of making that happen and/or having something left at the end

While I don’t expect anything spectacular to happen with Webco anytime soon, this is also the kind of stock that at some point in the future could suddenly become worth a lot more. The Weber family might for example want to monetize their stake in the company, and for an acquirer I can imagine that this company is worth close to book value. It might not happen this year, next year or even next decade, but you get a bit of optionality on a very positive surprise.

Disclosure

Author is long Webco Industries

Ming Fai announces sale of investment property

Ming Fai announced today that the company sold their investment property in Hong Kong for a consideration of HK$263 million. These properties were valued at HK$198 million as at December 31, so this is pretty good news. It’s however not unexpected news. On the 31st of May this year Ming Fai already announced that they were looking to sell the property, and on the 1st of August they signed a letter of intent to sell the property for HK$263 million.

What will be done with the cash that is generated with the sale remains an open question for now. I like that they have sold an investment property that has nothing to do with their main business: the manufacturing and distribution of amenity products. But based on the following language I don’t expect that a lot of capital will be returned to shareholders soon. This is unfortunate since Ming Fai’s history of investing outside their core-business is a bit spotty.

The net proceeds to be received by the Vendor from the Disposal will improve the overall cash position of the Group for general working capital purpose as well as for future opportunities that may arise

While the stock price is up roughly 13% since the company announced the signing of the letter of intent I think Ming Fai is still very attractive today. If I update my valuation model of Ming Fai for the HK$263 million sale price I get the following picture (with a HK$1.04 stock price):

Ming Fai valuation based on updated property price

Disclosure

Author is long 3828.HK

Elliott Associates completes tender offers for QFAL and QFID

Elliott Associates announced today that it would accept all shares that were tendered in the offers launched for Fondo Alpha and Immobiliare Dinamico, despite getting less than 50% of the outstanding shares of the two fonds. The tender offer for Fondo Alpha was the biggest success, and Elliott Associates managed to acquire 24.8% of the outstanding shares for a total consideration of €33.5 million. In the Immobiliare Dinamico offer just 2.5% of the outstanding shares were tendered for a total value of €2.8 million, but together with open market purchases they managed to get a total stake of 4.9%. In the offer for the Polis fund that closed a month earlier they acquired 16% of the outstanding shares. I didn’t sell my shares in the offer, and based on today’s market reaction that seems to have been a good choice. Fondo Alpha is now trading 3% above Elliott’s offer while Immobiliare Dinamico is trading 0.2% above the offer.

Promotional material from the Fondo Alpha offer

Disclosure

Author is long QFAL.MI and QFID.MI