Author Archives: Alpha Vulture

Nzuri Copper receives final regulatory approval

Nzuri Copper announced today that it received the last required regulatory approvals in China. When I wrote about the company in July the merger was already delayed, but by then the company was aiming for a close at the end of August. They obviously failed to hit that target, and the expected merger date was pushed back many times more. Of course, it’s still not a done deal, and in today’s announcement the expected closing date of the merger is now early March. But with all regulatory approvals in the pocket I don’t expect that there are more issues remaining that could cause further delays.

While in the end I got the result I was betting on, it’s tough to say in hindsight if my thesis was correct or not. It’s quite possible that those delays were indicative of a real problem that could have blown up the merger. Or perhaps it was just some administrative issue. Who knows?

Location of Nzuri's Kalongwe Project in Congo

Disclosure

Author is long Nzuri Copper

2019 end-of-year portfolio review

With another year behind us it is time again for another portfolio review. On Twitter it almost seemed that everybody had >100% returns this year, but my return was more inline with that of the index. Given the fantastic performance of the index this year I’m pretty happy with that, especially since the many special situations I invest in have usually a very low correlation with the stock market. I have been saying for years that I expect my portfolio to do relatively well when shit really hits the fan, but besides a small blip in 2018 it’s not a thesis that has been really put to the test. Nevertheless, I managed to beat the index for the eighth straight year since starting this blog. For sure a result that is way better than expected when I started investing.

Year Return* Benchmark** Difference
2012 18.44% 14.34% 4.10%
2013 53.38% 17.49% 35.89%
2014 30.11% 18.61% 11.50%
2015 24.23% 8.76% 15.47%
2016 64.97% 11.09% 53.88%
2017 29.04% 8.89% 20.15%
2018 13.07% -4.85% 17.92%
2019 32.34% 28.93% 3.41%
Cumulative 835.23% 157.17% 678.06%
CAGR 32.24% 12.53% 19.71%

* Return in euro’s after transaction costs, net dividend withholding taxes and other expenses
** Benchmark is the MSCI ACWI (All Country World Index) net total return index in euro’s

This year the basket of special situations managed to grab the top spot in my performance attribution graph, as you can see below. The biggest contributor to its performance was from a liquidation that provided a positive surprise worth 163bps while the reversal of the Sorrento Tech liquidation payment got a solid second place with a 157bps contribution. The worst performer in the basket was the Pacific Biosciences of California merger with Illumina with a negative 55bps contribution. I thought this deal wouldn’t face unresolvable regulatory issues, but that turned out to be very wrong, and four days ago the companies announced that they terminated the merger agreement. But it was clear from the start that there was some risk, and I’m pretty happy with how I sized the position. But perhaps I should have stayed away, handicapping this kind of regulatory risk is probably not where I have my biggest edge (if any).

Last year HemaCare was the biggest contributor of the portfolio with a 221% return. This years gain was almost equally impressive 146%, and thanks to a bigger starting allocation it provided a bigger contribution to the performance of the portfolio than last year (even after selling some shares early in the year). The final boost to its performance was provided mid December when Charles River Laboratories agreed to acquire the company for $25.40/share in cash. While I’m still waiting for the money to hit my account the merger was completed in record time. In just two weeks the transaction closed, even though this period included the Christmas holidays and New Year’s Eve. Perhaps they didn’t want people to try to exercise their appraisal rights? Or maybe I’m just a grumpy old guy to assume nefarious intentions…

At the bottom of the graph we find a couple of familiar value stocks. As a group the classic value stocks in my portfolio didn’t do very well, but both PD-Rx and Scheid Vineyards performed poorly operationally during the year so we can’t just put the blame on the market for not liking these companies. With PD-Rx now trading at net current asset value while Scheid Vineyards owns property worth many times its current market cap there is a reasonable case for continuing to own them at today’s price, but the stock I’m more enthusiastic about is Conduril. But the market and I have been in disagreement for more than seven years on that stock, so the chance that I’m wrong is certainly going up as well.

Last year my New Years resolution was to start bumping up my blogging frequency a bit again, something that didn’t really happen. I’m not going to put out there another failed New Years resolution, so I will just finish this post with wishing you all a happy a new year!

Disclosure

Author is long most of the stuff in the performance attribution graph

Charles River Laboratories to Acquire HemaCare

Yesterday the news broke that Charles River Laboratories (NYSE:CRL) is acquiring HemaCare (OTCMKTS:HEMA) for $25.40/share in cash. I bought my first shares at the end of March and the beginning of April in 2017 for an average price of $2.53/share, just low enough to make the stock officially my first ever “ten bagger”. With that kind of performance HemaCare was obviously a driving factor behind my portfolio’s performance for the last few years, even though I did end up selling some shares along the way.

While I can’t really complain that Charles River Laboratories is not paying enough when they are paying $380 million for a business that had $35 million in revenue (ttm) and net income of $6.9 million (ttm) I’m strangely enough a little bit disappointed. In the press release Charles River Laboratories notes that they expect HemaCare to contribute at least $50 million in revenue in 2020 and to grow revenues with at least 30% for 5 years after that. It’s tough to see how that would not work out more favorable for shareholders, but of course, that is only when they do manage to achieve those goals. That’s not certain, and being part of a larger organisation is perhaps part of what will make that growth possible. And before the first rumors about a potential sale surfaced the stock was trading around $16/share, so $25.40 is more than a fair premium.

For those readers that are looking at this as a merger arbitrage, I think it’s marginally attractive. With the stock currently trading at $25.10 the spread is just 1.2%, but the merger has already received shareholder approval and is expected to close early in the first quarter of 2020. I don’t think there is anything that could realistically derail this deal, so while the spread is thin I think it’s okay. There are certainly lots of deals with smaller spreads and more risk.

Disclosure

Author is long HemaCare

Some comments on Aswath Damodaran’s Aramco post

I suspect that many readers of this blog also follow the blog of Aswath Damodaran, and if they don’t, I would recommend doing so. Damodaran is a Professor of Finance at the Stern School of Business and he often posts how he would approach valuing high-profile stocks such as Tesla or Uber. It’s very unlikely I would ever be interested in investing one of those companies, but his valuation methodology is pretty solid and his posts are educational. I think having a good grasp on the fundamentals of valuing a company is very important, even when most of the time you revert to simple back of the napkin valuations using a P/E multiple (which I do).

However, I disagree strongly with his approach in his latest post about how to incorporate truncation risk in the valuation of Aramco. To quickly recap Damodaran point of view, a DCF valuation is only suitable for going concerns because you assume cash flows are continuing long-term and potentially indefinitely. Because of that you can’t properly model survival risk where a company might cease to exist after a certain point in time. In the case of Amerco it could be a possible regime change at some point in time to fundamentally change the value of the business going forward. But it’s also very relevant in startups that have a high probability of not making it past the first few years. His suggested solution is to value the company as a going concern in one scenario, value it with a regime change in a second scenario, put some probabilities on the two scenarios and call it a day.

Aramco equity valuation model incorporating regime change risk, source: Aswath Damodaran

I think there are two problems with his post:

  1. This approach doesn’t work well because it doesn’t fit reality
  2. A DCF is perfectly capable of incorporating truncation risk

The reason that this methodology is flawed is because it doesn’t incorporate the timing of the potential event. It matters a whole lot if the regime change is in the next year, or if it happens in 30 years time. So what does a 20% probability mean? Is that a 20% probability of regime change happening this year? the next 5 years? the next 50 years? And because that question isn’t answered, you also can’t really do a equity valuation in the regime change scenario. What he is doing I think is just taking the going concern equity valuation, and reducing it by 50% in the regime change scenario to account for higher taxes and royalties. That implicitly assumes that the regime change will happen on day one, which is of course highly unlikely and unrealistic.

A better model would be to assume that there is a small probability of a regime change every single year. That sounds complicated, but luckily, that’s exactly what we can model in a DCF by increasing the discount rate. If you would for example assume a 1% probability that there is a regime change in a given year you can simply increase your discount rate by 1%. It’s that easy! A one percent chance for 10 years in a row would imply a probability of regime change of 9.56% during that period and 39.5% during a 50 year period.

Note that by increasing the discount rate by one percent in case of a regime change we are assuming that the residual value is zero. If you think there is a 1% probability with 50% residual value we should increase the discount rate by just 0.5%. And a second small note, if you want to do things mathematically correct, you can’t simply add probabilities. In the example below you can see how that becomes especially relevant when probabilities become large.

If you want you can also easily change the model to customize probabilities of failure for each time period. Perhaps you have the view that there is in the next five years a higher chance of regime change, followed by a period of lower probabilities. But it’s probably more useful when thinking about a startup. The probability of failure is presumably very high in the first few years while lower in subsequent year.

Let’s imagine a project that will costs 10 million to start and 10 million more at the end of the first two years, and will produce 100 million at the end of year 3 and 4. In the first two years there is a 25% probability of failure. We could (and should!) model that as following:

Hypothetical cash flow model with high risk of failure in first two years

Note that the discount rate is calculated by taking: (1 + "equity risk") / (1 - "truncation risk") - 1 and the NPV factor is the factor of the previous year multiplied by 1 / (1 + "discount rate") of the current year. That way you carry a risk of total failure that you introduced in the early years forward for the calculations of the NPV of later years1.

The great thing about this model is that it matches actual reality. If you have a failure in the first year you don’t have to put more cash in the project, that’s why the net present value of the cash outlays at the end of year one and two are severely discounted. And of course, the same is true about the payoff in year 3 and 4 because there is a high probability that the project will never get to that point. If you would want to model this using Damodaran’s approach you would be in big trouble, because one single failure scenario can’t easily account for the fact that failure can occur at different times, and that the impact on the net present value depends on the timing.

Concluding remarks

Let me know in the comments if you found this post useful, otherwise I will be back to posting the occasional merger with a contingent value right ;). And of course, perhaps you want to point out that I’m completely wrong. It’s totally possible that I don’t know things better than someone who is a professor of Finance.

Disclosure

No intention to ever initiate a position in Aramco

1. A previous version of this post was using the wrong formula to calculate the discount factor and the combined discount rate. Thanks to a reader in the comments this has now been corrected.

A last minute merger arbitrage in Celgene

Today is the expected closing day of the merger between Celgene (NASDAQ:CELG) and Bristol-Myers Squibb (NYSE:BMY). All regulatory approvals have been received so there is basically nothing anymore that could derail this deal. Bristol-Myers is acquiring the company for one share of stock, a $50 cash payment and a CVR that will pay an additional $9 dollar if, and only if, three treatments that are in development receive FDA approval. With CELG trading at $107.80 at the moment of writing and BMY trading at $55.70 investors can buy the CVR for $2.10.

A hint that this might be on the cheap side can be found in this SEC filing made by Bristol-Myers in May earlier this year where the company puts an estimated fair value of $3.83 on the CVR. They don’t provide an break down how they arrived at this value, only this:

The preliminary estimate of the fair value of the CVRs was determined by applying a probability weighting to the potential $9.00 per share payment reflecting the probability of achieving all three necessary approvals. The probability-weighted value was then discounted to present value using a credit risk-adjusted discount rate.

Since that time all three treatments have progressed as planned, so presumably if they would redo this valuation today it would be higher. The three approvals that they need to get are:

  • Ozanimod (by December 31, 2020)
  • Liso-cel (JCAR017) (by December 31, 2020)
  • Ide-cel (bb2121) (by March 31, 2021)

These deadlines seem to be tight, and the combined probability of three events happening is obviously quite a bit lower than the probability of individual events, so there is reason not to be too enthusiastic about the CVR. But these treatments are all in a very developed stage of development, and the base rates of success of going from Phase III to approval or from NDA/BLA to approval are quite high. Celgene gave the following update with regards to above treatments when the company announced their results for the third quarter:

I’m not a medical expert, but given that base rates for success at this point are pretty high I think you could even make a case that the $3.83 valuation made by Bristol-Myers is somewhat conservative. These are all events that should be in the range of 75%-85% or something like that and taking very crudely 75%^3*$9 gives us a value of $3.80. This ignores that time value of money, but given that the deadlines are all relatively soon I think that doesn’t matter too much.

Because the deal will close very soon and I think that right now the CVR is probably attractively priced I bought a significant amount of CELG with a corresponding short position in BMY.

Disclosure

Author is long CELG, short BMY