Exited Webco Industries position

Today I finally managed to sell my position in Webco Industries. It was on my sell list for some time, but given the illiquid nature of the stock (before today only 100 shares had traded in more than a month time!) some patience was required. Someone put a nice bid in the market, and I decided to take advantage of the opportunity. When I bought my position the stock was trading at a 40% discount to NAV and I figured that upside was between 50% (looking at historical earnings power) and 100% (looking at liquidation value). Since then the stock has gained 60%, exiting net-net territory, while fundamentally nothing has changed. Perhaps the market is anticipating lower corporate taxes, and/or a better outlook for the steel business thanks to Trump, but I’m not going to bet on that. To me the stock seems pretty much fairly valued now:

Disclosure

Author has no position in Webco Industries anymore

Goldin Properties Holdings merger arb

Goldin Properties Holdings is a Hong Kong listed property developer that focuses on the high-end property market in China. The CEO, who owns 64.4% of the outstanding shares, is trying to take the company private and is offering HK$9.00/share. With the shares currently trading at HK$8.28 there is a decent spread of 8.7% left that implies that the market is skeptical about this deal going through, although the CEO has financing in place and is offering a fair premium.

The privatization is being done using a tender offer that opened yesterday, and will close the 10th of May (unless extended). One risk factor is that not enough people will tender their shares since 90% of the minority shareholder need to tender their to make the offer unconditional. Since there are always people who are too lazy to tender, not aware that they can tender their shares or have their shares with a broker that frustrates the process this poses a small risk. It also doesn’t help though that the company doesn’t have large institutional owners. So there might be many small retail shareholders who might not tender for one reason or another. But usually enough people will tender in a case like this, and it helps that Goldin Properties has a US$3.8 billion market cap, so it’s a deal that will get some media attention.

The biggest reason for the spread is probably that this is a stock with a bit of history. It managed to make some headlines in 2015, first after climbing in almost a straight line from less than HK$5/share to almost HK$30/share in almost two months, and then giving most of the gains away in just one day. Certainly weird, but as far as I can tell not because of nefarious actions from the company itself. Just some unhealthy speculation from investors in Hong Kong:

So I guess this merger is a little bit more hairy than most the Chinese mergers I’m involved in, but I don’t see any big risks here and with a spread of 8.7% I think it’s worth a gamble.

Disclosure

Author is long Goldin Properties Holdings

Industrial Milk Company: farming in Ukraine

Coincidentally, Black Earth Farming isn’t the only farming company in the Russia region that hit my radar this month. Before stumbling on that merger idea I was already looking at Industrial Milk Company. Despite its name, the company is mainly focused on raising crops. Its assets are located at the other side of the border, in Ukraine, and it has roughly the same size as Black Earth Farming while focusing on the same mix of crops. So I think the transaction is a nice data point that can act a bit as a sanity check on our valuation. I started looking at Industrial Milk Company based on a tip from a reader, who described it as having a normalized P/E ratio of 2x. While investing in Ukraine isn’t without risk, that’s certainly cheap enough to arouse my interest. Before we continue discussing the company in more detail, some quick statistics first:

Ticker: IMC:WSE
Latest price: 9.86PLN ($2.48)
Market cap: US$77.5 million
P/E: 7.15
P/B: 1.10
EV/EBIT: 3.22
EV/EBITDA: 2.71

Based on these statistics the company doesn’t immediately looks like a screaming buy, but there are a lot of moving parts that impact the income and balance sheet statements. Industrial Milk Company has the Ukrainian Hryvnia as functional currency while using the US dollar as presentation currency, and as a result it has been incurring large FX losses the past years. Since its assets are mainly land and machinery while it sells most of its production internationally these losses are presumably mostly accounting issues, not real economic losses.

In addition, the company recognized a $16 million loss in the trailing twelve months because it loaned money from the IFC that came with a warrant agreement that allowed IFC to claim $21 million if it would not exercise the warrants. With the warrants having a strike at $6.45/share while the stock is currently trading at $2.48 they obviously went for the cash payment. Bit weird accounting wise in my opinion, but certainly shouldn’t be a recurring issue. Because of this additional liability net debt stayed stable the past nine months even though the company generated a good amount of cash flow:

Normalizing earnings by ignoring FX losses and adding back the “Loss on recognition of additional return on financial liability” is tempting to do (the company does this, see for example page 5 here), but based on the amount of free cash flow the company is generating I think that is a too optimistic approach. To be honest, I have a bit of trouble figuring out where the earnings disappear. Since the company is valuing their biological assets at fair value there is a large non-cash component to earnings, and part of that disappears as a non-cash element of “cost of sales”, but inventories, biological assets and receivables aren’t really growing. Guess that must be because of the FX losses?

So instead of using earnings, I’m inclined to look at free cash flow as the best way to value the company. But that’s also a bit tricky, since cash generated from operations hasn’t been very stable historically. The past three years have been solid, but before then results have been more mixed.

As a starting point I will take TTM cash from operations of $36.9 million, add back interest expense of $13.1 million and subtract depreciation of $8.5 million. Current capex is below depreciation, but I have no reason to believe that that is sustainable. It might even be too low if the book value of the PP&E is artificially low due to the FX losses. This gives a total cash flow that is available to the whole firm of $41.5 million. Now the big question is what kind of return should investors require here. Industrial Milk Company is not some save western company, and that is reflected in the interest rates that the company pays on its USD loans that are between 10 and 12%. Add an equity risk premium of something like 6%, and we probably should require a return of roughly 17.5% on unlevered equity. That would mean that the whole company is worth $237 million. Subtract $91.9 million in net debt and we arrive at an equity value of $145.2 million: implying that there is roughly 85% upside from the current market price. Not bad, but also not as high as you would have hoped if the starting promise is a 2x P/E ratio.

We can use the Black Earth Farming as a bit of a sanity check of what the company should be worth as well. Some statistics side by side, and the implied upside:

The financial statements of IMC might be difficult, but when you buy a farm in the end not a lot of variables matter. How much land you buy (as measured by surface area) and how many crops grow every year on it (measured in tons and/or dollar value) is basically everything you need to know. And based on this I think my simplistic free cash flow model is pointing in roughly the right direction. Just based on hectares the upside potential isn’t that big, but IMC is a lot more productive based on sales volume and total revenue. With 1.5x more equipment, 1.5x times higher production volumes and 1.4x times higher revenue I would say that IMC in an optimistic valuation is maybe roughly worth 50% more than Black Earth farming: so $300 million. After accounting for the debt that would mean an upside potential of 168%.

Conclusion

Industrial Milk Company is for sure not expensive, but at the same time I’m not yet totally convinced that it is a great buy. If you take a leveraged company and value it based on the acquisition price of a comparable almost anything will look great. Based on free cash flow it is still a decent deal, but I’m worried that basing my valuation on just the past twelve months is also too optimistic. Historically, the conversion of operating earnings to cash hasn’t been great. So I’m still a bit on the fence if I should buy it or not. The upside is there, but it isn’t insanely big and at the same time I have a bit of troubles fully grasping how the accounting works.

What do you think?

Disclosure

Author has no position at the moment

Black Earth Farming merger arbitrage

Black Earth Farming is a Russian company that is listed on Nasdaq OMX Stockholm. Earlier this year the company announced that it had entered into an agreement to sell its Russian assets and liquidate the company. Yesterday the company received regulatory approval in Russia for the deal, removing the last potential obstacle to complete the transaction. Because of how the deal is structured there is some uncertainty about what the final payout will be, and that combined with the Russia factor probably explains why there is a decent spread left while the deal completion risk is almost completely gone.

The acquiring party is not simply acquiring all shares of Black Earth Farming, but it is buying the operating subsidiaries in Russia for approximately $184 million. At the holding company level $46.9 million in debt will remain, and approximately $50 million of working capital as well. The company expects to incur $5 million in costs to wrap-up the liquidation, and there are some warrants outstanding that will presumably be exercised as well. These things make the picture more complicated, and some uncertainty is added by the fact that the final price will be adjusted based on the total amount of intragroup loans and “certain purchase price adjustments”. The company anticipates that between $185 million and $193 million will be available for distribution to shareholders. Simply taking the midpoint of this number is a reasonable guess in my opinion, because usually these estimates are slightly on the conservative side. The person making them has nothing to gain by overestimating those numbers, while if they are too optimistic they might get unhappy shareholders and/or lawsuits.

If we take the midpoint of $189 million and divide this by 228.7 million of shares (this includes 18.3 million shares from the exercise of warrants and options) we get a per share amount of $0.826 or SEK 7.45. With the shares trading at SEK 7.00 this implies a spread of 6.4%. Not bad for a deal that is expected to close in May while the payment  to shareholders is scheduled for late June. There is some risk that the payment will end up being lower, but I think that is mostly variance with a neutral expected value. It could just as easily end up higher than lower.

There might also be a little bit of upside remaining after the initial distribution to shareholders. Black Earth Farming has earmarked $5 million for wrapping up the company, but if that amount proves to be too high (seems like a lot to me) the remaining cash will be distributed to shareholders as well. It will not be a lot, but I expect that it will be more than zero. Again, this is one of those things were underestimating the costs is only going to cause big troubles while picking an amount that is for sure sufficient has no real drawbacks.

Disclosure

Author is long Black Earth Farming

Exited Boom Logistics

Almost 3 years ago I entered a position in Boom Logistics with a simple thesis. The company, that specializes in renting out cranes, was at that point in time trading at A$0.135/share while it had A$0.51/share in tangible assets, mostly consisting of cranes and other big equipment. My bet was this equipment could easily be sold for a price closer to book value than the market was implying, giving downside protection even if the business would not turn around.

Now that we have moved forward a couple of years in time it’s easy to check if that was indeed true, and it appears that I was wrong. The business has so far not yet turned around, and while Boom Logistics managed to use equipment sales to manage their debt load net tangible assets per share dropped to A$0.33 in the mean time. In the first half of FY2017 the company for example transferred A$4.7 million in equipment to “assets held for sale” while recognizing an impairment loss of A$1.9 million, implying a discount of 42% to book value. If we take a bit of a short cut and apply the same discount to their whole fleet of cranes we get a NAV/share of A$0.16. Still a bit higher than the latest share price of A$0.12, but it’s a marginal difference (and in 2016 the discount was actually bigger). So I sold my position today, incurring a loss of 11.1% on my purchase price. Obviously not a great result, but you can’t be right all the time. Although in this case, I’m pretty sure that if I would have followed the company closer I would have recognized that my thesis was broken earlier. So that’s something I’m trying to improve on.

Disclosure

No position in Boom Logistics anymore