Monthly Archives: December 2014

Entered the ATLS/TRGP merger arb/stub trade

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After my post on the Atlas Energy merger arb/spin off a lot has changed in just a few days because the carnage in the MLP land has continued unabated. This also has had big effect on the implied new Atlas Energy Group stub price that has tumbled from $4.21/share to $0.42/share. This is however a bit of a deceptive figure since it does not account for the merger risk inherent in buying the stub. We can estimate the merger risk by looking at the NPL/NGLS deal that is codependent on the ATLS/TRGP deal, and the deal spread has grown together with the carnage in the sector. If we adjust for the merger risk we get the following price:

Implied price Atlas Energy Group

The estimate of the merger risk is of course just that, an estimate, because while both deals have the same probability of completion the downside risk might not be identical when the deal fails. I don’t think this difference is material though, although the ATLS deal might have a bit more risk since a larger percentage of the price is paid in cash. But we also get paid a whole lot more than the 7.13% of the APL/NGLS deal. If we only look at the value of the ARP LP units that the new Atlas Energy Group owns we already get a value of $2.26/share:

ARP LP units value minus debt

In addition to this we also get:

  • 100% of the GP and IDR units of ARP (probably worth at least $0.50/share in current environment and a potentially extremely valuable option on a oil price recovery).
  • A 12% LP stake in Lightfood that owns 40% of ARCX (worth $0.29/share).
  • A 15.9% GP interest in Lightfood (no idea how valuable).
  • A 80% GP interest in the E&P development subsidiary and a 2.5% LP interest.
  • 11.5MMcfd of gas production in the Arkoma basis (valued by management at $1.15/share, and gas prices have remained basically unchanged)

I honestly don’t know exactly how to value all these various interests, but when you get a bunch of potentially valuable assets basically for free I think this almost has to be a good bet with a positive expectation. So I have initiated a small position yesterday. Anything else than a small position is probably not wise/doable though since you need to tie up a lot of capital, and you get a lot of deal risk as well. You could theoretically hedge the deal risk to some extent by shorting APL and buying NGLS, but that would require even more capital.

Disclosure

Long ATLS, Short TRGP. No (direct) position in ARP, ARCX, APL or NGLS.

Atlas Energy merger arb/spin off opportunity?

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Someone on Twitter posted a slide from the latest investor presentation from Atlas Energy that piqued my interest. The majority of the company is being acquired by Targa Resources, but before the transaction is closed a small part of the company is being spun off to existing shareholders. Management seems to believe that the implied price of the new Atlas Energy Group is substantially below intrinsic value:

Atlast Energy Group implied valuation

The merger perspective

While this sounds great we have to realize that at least a part of the possible undervaluation represents a merger risk premium. The size of the risk premium should however be small since:

  1. Both stocks showed a muted market reaction when the deal was announced (so the downside should be limited as well)
  2. The deal is for a large part in stock so the price is automatically adjusted (to some extent) based on changing conditions in the oil and gas market
  3. Regulatory concerns should be zero given that we are talking about two relative small players in a commodity business (and the companies indicate in the merger agreement that no approval from any government authority is required)
  4. The merger agreement seems to be airtight since neither changes in market conditions nor extreme events such as disasters or the outbreak of war are valid events for termination.

The only negative is perhaps the fact that the termination fee is ‘just’ $53.4 million, or approximately 3.6% of the current deal value. If Targa Resources would really want to get out from the agreement they could do so. Since both stocks have moved in aggregate a limited about since the deal was announced in October, and with a very high correlation, I doubt that anything has changed so far that would lead to the acquiring party wanting to cancel the deal.

Since we are receiving one security with an uncertain value it is impossible to calculate what the potential return of the merger arbitrage is, but this might exactly be the reason why there is an opportunity here. People who ordinarily would play the merger arbitrage game might not enter because they don’t want a large exposure to the new Atlas Energy Group that cannot be hedged. At the same time the people who would want to buy just the new Atlas Energy might not be interested in the merger arbitrage game since you need a lot of gross exposure to ATLS and TRGP to buy a small new Atlas Energy position.

Valuation

What the potential return is of the combined merger arbitrage/spin off depends of course critically on the intrinsic value of the new Atlast Energy. The management team seems to think that the disconnect between price and value is pretty huge:

Managements estimate of the new Atlas Energy GroupSome of these numbers are already outdated and a bit lower while other are potentially too optimistic, but if it’s roughly right you still get a great deal. The stub is currently trading for $4.21, so if it’s worth $13 you would be looking at more than 200% upside! That should give you some wiggle room to adjust certain items downwards.

Almost all value is related to Atlas Resource Partners. The company owns 100% of the General Partner (GP) Interest, 100% of the Incentive Distribution Rights (IDRs) and a 27.7% Limited Partner (LP) Interest. The limited partnership units are easy to value since they are traded on the NYSE under the ARP ticker. The general partnership units are also relative straightforward since they are entitled to 2% of ARP’s cash distributions. With ARP currently trading at a >19% yield I think we have to conclude that the current distributions are not sustainable, and that makes sense since oil prices have dropped a lot. Perhaps a bit crude, but if the current price is right a fair yield is probably roughly half the current yield. This would mean that the company would distribute approximately $100 million per year to LPs, and as a result the GP would be entitled to ~$2 million/year. This would also imply that the IDRs would be far out the money since they only start to generate cash flow at distributions of more than $0.47/quarter. This represent a yield of more than 15% at the current market price.

So I have a huge discrepancy between the fair value estimate from management and my own estimate. A $17 million revenue stream at a 20x multiple (pretty high) is worth $6.50/share. A $2 million revenue stream at a 15x multiple is worth just $0.60/share and would eliminate almost all upside even if we take all other estimates at face value (I think some need to be adjusted downwards, but not by a whole lot).

So I’m I being too pessimistic here? Is the market too pessimistic about ARP? The management team seems to think so if we believe the Q&A from the latest conference call (emphasis mine):

Thanks Lee. Well of course I think our latest acquisition demonstrated how we can actually grow, we expect profitably without issuing additional equity at these ridiculously low prices. Although one should note that the entire sector wrongly in my opinion is creating yields that are in double-digits. So that part is really foolish, but you will know more about the market than I do. But I do know that with the imagination as we’ve demonstrated one can do deals even where common wisdom would say you can’t do great deals. And I think our counter cyclical approach has proven to be very useful in the past and we’re just watching as the panic in the oil patch increases, we’re in a position now to diversify nicely.

Or are they perhaps right and is there here indeed a great opportunity? And if they are right wouldn’t it make more sense to buy ARP directly? What do you think?

Disclosure

No position in ATLS, TRGP or ARP at the time of writing.

Exited my Veeva Systems short

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Exactly one year ago I entered my Veeva Systems short with the thesis that the company would have limited growth potential going forward. Given that it would become apparent soon enough if this would be true I decided from the onset to hold to position for just one year. Unfortunately the company continued to show healthy growth this year with revenue up more than 50% in the latest quarter compared with the same period previous year. Luckily I still made a decent amount of money on my short since the share price dropped with a bit more than 25%. I guess that shows the attraction of shorting a highly valued stock. Even when the news is good it might not be enough. Or I just got lucky: that’s always a viable explanation too…

Disclosure

Author has no position in Veeva Systems

Clark Inc revisited: a bargain after all

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When I looked at Clark two weeks ago I thought that it was an interesting company, but not a great deal at the current discount. Fortunately my readers alerted me in the comments that there was a little bit more to the story than I thought. The company has a pension asset that is not recognized in the book value making the actual discount bigger than I calculated, and at the same time there is no tax liability for the pension assets that are on the books (there is only an unrecognized liability for the unrecognized assets).

In the past two weeks the company also sold its stake in Supremex, bought back a bunch of shares while its share price dropped almost 10 percent. This means that the current discount to (adjusted) book value is a lot higher now:

Clarke Inc discount to NAV

An adjusted discount of almost 28% isn’t too shabby considering the decent track record of value creation at Clarke. This discount doesn’t incorporate a liability for the expected overhead at the holding company level, but it also doesn’t incorporate the alpha that the company creates by buying back shares and paying a dividend. I didn’t incorporate this in my model when I first posted about the company because I thought that the discount to intrinsic value was minimal. Buying back shares and paying a dividend doesn’t generate meaningful value when the discount is small. But it certainly does when the discount is almost 30%:

Clarke Inc adjusted NAV

The company is currently on pace to buy back 5% of its outstanding stock this year. Buying one share at CA$9.90 that is worth CA$13.70 generates a profit of CA$3.80. Multiply this number with 5% of the outstanding shares and you generate CA$3.7 million/year. Capitalize this stream of alpha at a 10% discount rate and the value of the share buyback opportunity is CA$37 million. The value of the dividend can be calculated in a similar manner since you can use the dividend to buy additional shares yourself. Since the dividend represents a 4% yield the potential value of the dividend is roughly four fifths that of the share repurchases.

At the current discount the value of these two streams of ‘alpha’ is significantly more than the negative value of the holding company overhead. It is important to realize that this calculation does not imply that the fair value of Clarke is CA$16.11/share because at that share price repurchasing shares would actually shrink NAV/share. With a little bit of trial and error we can find the share price where the ‘adjusted discount III’ is zero:

Clarke Inc fair value

This means that Clarke Inc should be trading close to book value. But given the reflexivity between intrinsic value and price this doesn’t mean that the current intrinsic value is CA$13.13/share. The longer the company continues to trade at a discount the more valuable it becomes. This will give shareholders two ways to win. If the discount persists or grows the company will be able to grow intrinsic value at an above average rate while a shrinking discount would imply, ceteris paribus, a higher Clarke share price.

Of course this is all assuming that George Armoyan is neither expected to outperform nor underperform the market. While I was skeptical about his abilities/his track record in my initial post on the company I do think it’s more likely than not that he is able to generate some positive alpha. A ten year 14.4% CAGR versus 5% for the S&P/TSX is pretty decent after all, even with lumpy results and a lot of underperforming years. And the most important thing is that you are absolutely not paying anything for this possibility at the current price point.

Conclusion

Clarke is not the proverbial 50 cent dollar, but I don’t think it’s wise to focus on a more or less arbitrary hurdle. What’s very important is how certain you are about the undervaluation. A company that you know for certain is undervalued by 10% might be a better bet than a company that you think is undervalued by 50%. One of the biggest reasons that you need a margin of safety is in my opinion to protect yourself against valuation mistakes. Given the relative straightforward valuation of Clarke I think there is a pretty low probability that I’m wrong about the appropriate discount for the company.

It also makes sense to be willing to accept a slightly lower discount when you have a little bit of faith in the capabilities in the manager. You could of course try to incorporate this in the valuation model, but that would be pretty arbitrarily I think.

Bottom line is that Clarke is almost certainly too cheap at the current price, and with both a decent share repurchase program and a nice dividend yield there is a solid opportunity for both the company and shareholders to create value. Given the large cash balance after the sale of Supremex there might even be more in the cards than just the current repurchase program.

Disclosure

Author is long Clarke Inc

Mota-Engil Africa debuts on Dutch stock exchange

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Last week Mota-Engil listed the shares of its African subsidiary on the Euronext stock exchange in Amsterdam. The company cancelled an IPO in London earlier this year and has now spun off 20% of the African subsidiary to shareholders. Mota-Engil wanted to IPO a part of the subsidiary at a price between €11.50 and €14.50. After opening at ~€11.50 last week the stock is now trading a bit below this range at €10.50 giving it a €1 billion market capitalization.

The valuation of Mota-Engil Africa is very interesting because I think it’s a very good comparable to Conduril. Conduril generated 93% of its revenue in Africa the past year, and they are for a large part active in the same countries. Mota-Engil Africa is active in the following countries:

Mota-Engil Africa activities

Both companies are big in Angola. Angola accounted for more than 50% of Mota-Engil Africa’s revenue in 2013 and Conduril is getting a similar percentage of its revenue from Angola. Conduril is also active in Zambia, Malawi, Mozambique and Cape Verde. Mota-Engil Africa is a lot bigger than Conduril though. They don’t even mention the company as a competitor in the listing prospectus when discussing the competitive landscape in Angola:

The Angolan construction industry had 44 major international contractors in 2011, however the industry is dominated by companies from Portugal, Brazil and China. Portuguese and Brazilian companies (or companies with ties to Portugal and Brazil) have leveraged strong cultural ties to build an established presence in the country with the Group, Teixeira Duarte, Somague Engenharia and Soares de Costa from Portugal and Odebrecht and Camargo Correa from Brazil winning the majority of new projects up for tender. In respect of Chinese firms, the model is slightly different, where China has acquired Angolan resources in exchange for infrastructure investment. Furthermore, extensive credit lines have been extended to Angola, although these are specifically to fund projects built by Chinese companies. As of 2011, there were 22 Chinese construction companies present in Angola.

While I do think that Mota-Engil Africa is a good comparable to Conduril the two companies are certainly not identical. Mota-Engil Africa is not only a lot bigger, but has also shown faster growth in the recent years as illustrated in the table below:

Revenue growth: Conduril versus Mota-Engil Africa

It also looks like Mota-Engil Africa will be able to continue its fast growth in the near term since they have been awarded a project worth US$3.5 billion in Cameroon (conditional upon financing being secured). Their biggest contract is currently the almost completed Malawi Nacala Corridor Railway Corridor that is worth €691 million. Because of the growth difference Mota-Engil Africa should trade at a premium compared to Conduril. But this much?

Valuation metrics Mota-Engil Africa versus Conduril

I don’t think so. A big project is nice for Mota-Engil, but it’s probably not sustainable growth since it will probably be extremely difficult to replace their backlog once it’s completed. With a P/E-ratio of 10.84 the market is presumably also not expecting growth miracles from Mota-Engil Africa. So it should be a reasonable comparable, and possibly undervalued itself given where it is trading compared to the proposed IPO range and the relative low P/E-ratio given its growth.

Disclosure

Author is long Conduril, no position in Mota-Engil Africa