Category Archives: Research

Atlas Energy merger arb/spin off opportunity?

10 Replies

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.

Clark Inc: the Canadian Icahn at a discount?

13 Replies

Clarke Inc is a Canadian holding company that is run by activist investor George Armoyan. Just like Carl Icahn George Armoyan has a bit of a reputation as a bully. He actually got banned from a couple of municipal buildings in Halifax last month because of ‘threatening’ behavior:

“They made me wait for an hour and 15 minutes without giving me the courtesy to come out,” said Armoyan, whose family company, Armco Capital Inc., is one of the largest development firms in Atlantic Canada. “Then all of a sudden I see police guys come over because I was tapping my feet and I was looking agitated and angry.”

The attraction of Clarke is that the company is trading at a discount to net asset value, the company is steadily buying back shares and it is paying a decent dividend. How big the current discount to NAV is is easy to calculate since the majority of assets are publicly traded:

Clarke Inc NAV

As is visible the company is trading a decent discount to NAV, but a discount less than 20% is ordinarily not enough to get me interested. Unless the investments of the holding company are capable of outperforming the market a holding company deserves to trade at a discount because it has overhead costs and there are usually tax inefficiencies.

Tax inefficiencies seems to be minimal at Clarke because it doesn’t pay taxes on capital gains or dividend income. It might have to pay income taxes when the pension benefit asset is realized. I wasn’t able to figure this out with certainty, but I do think it is probably that they have to pay 31% in income taxes when it is realized (if I have a reader that knows this for sure, that would be nice). Assuming that they need to pay taxes this would reduce NAV by CA$9.3 million.

The negative value of the overhead is a bit though to figure out since the company used to own operating subsidiaries that have their results consolidated. George Armoyan got paid close to a million dollars in pension benefits last year, but since he is now only the chairman of the board and not the CEO that might not continue. But the new CEO is obviously getting paid, they have a CFO and probably some other staff at the holding company level as well. And there is of course an auditor to pay, and I assume they have an office somewhere as well. At least CA$2 million in yearly operating costs is probably an optimistic estimate. Capitalize these costs at a 10% discount rate and we have another CA$20 million liability that is missing from the NAV. If we would include this and the taxes in the calculation the discount would be a meager 7.4%.

The last major component missing from the calculation is whether or not the investment manager is able to generate (positive) alpha. This is something that I usually don’t want to bet on, but in this case it might be reasonable. The latest quarterly contains the following graph:

Historical results Clarke IncThis looks like a pretty decent result, and it is. Book value increased at a 14.3% CAGR while both the S&P/TSX and the S&P 500 managed something closer to 5% during this period. While this sounds pretty impressive I’m actually a bit skeptical whether or not this result is attributable to skill instead of luck. If we ignore the past two years where Clarke posted phenomenal results the company would have performed roughly the same as the S&P/TSX for an eight year period but with more volatility. Not being able to beat the index for an eight year period sounds pretty crappy to me, but I might be overly harsh? It doesn’t inspire confidence.

Conclusion

If you think George Armoyan is able to beat the market Clarke is probably a pretty good investment, especially if he is able to beat the market at a significant clip. If he is unable to beat the market – and unfortunately that is for most investment managers the case – the company is probably just marginally undervalued.

To be fair: I haven’t included the impact of the share repurchases in my calculations. Buying back approximately 5% of the outstanding shares/year at a ~15% discount (taking taxes on the pension asset into account) should result in a little bit of alpha. It’s not very meaningful though.

Disclosure

No position

Jewett-Cameron’s segment revenue in two graphs

6 Replies

After my short post on Jewett-Cameron Trading I received some comments that by basing my valuation on net operating profit I was missing what was going on within the various segments, and this was certainly true to some extent. The graph below shows how Jewett-Cameron’s revenue mix has evolved the past ten years, and as visible it is fair to say that the company is now in a completely different business than a decade ago:

Jewett-Cameron revenue mix

Note that the column labeled 2014 is in reality the TTM and includes one quarter of 2013, but that’s something I’m unable to fix in Google drive. While the lawn, garden and pet segment has grown to be a very large part of Jewett-Cameron’s business the absolute growth of the segment hasn’t been that stellar. Revenue increased from $24.8 million in 2009 to $33.4 million today, representing a 6.5% compounded annual growth rate. If we don’t pick the lows of 2009 as starting point but the previous high of 2008 the compounded annual growth rate drops to 3.2%: not bad, but not great either.

Jewett-Cameron lawn, garden & pet segment revenue and profitability

The reported segment earnings before taxes also show few signs of operating leverage. Earnings before taxes grew at a 4.0% rate if we start measuring from 2009 and just 1.7% if we start at 2008. With those kind of growth rates just taking the average operating earnings of the past five years or so seems a pretty reasonable approach to me. You need a little bit of nominal growth to keep-up with inflation anyways.

I do agree that there might be some positive optionality if the industrial wood segment recovers. I don’t want to call this a free option since the segment has shown declining sales for five years in a row and is a bit below break even. They also do have some excess real estate that they will be able to monetize at some point in the future. But don’t think this is enough to revise my previous conclusion that the company is currently fairly valued.

What’s basically the case is that the lawn, garden and pet has been such a big part of Jewett-Cameron’s business for an extended period of time that drilling deeper doesn’t add a whole lot of value. What’s happening in the other segments is almost irrelevant now.

Disclosure

No position in Jewett-Cameron Trading

Jewett-Cameron Trading: a cannibal at fair value?

7 Replies

Jewett-Cameron Trading (JCTCF) ended on my research list after I noticed that they repurchased more than 10% of their outstanding shares in the latest quarter. This wasn’t the first time either that the company bought back stock: in the past five years the number of outstanding shares has dropped with more than 40%. Companies that aggressively repurchase their shares are in my opinion very interesting. It usually says something positive about the capital allocation and shareholder friendliness of the management team, and if it’s done below intrinsic value the share repurchases can create a lot of value. Before trying to figure out if this is also the case for Jewett-Cameron some numbers:

Last price (Jul 17, 2014): 9.29
Shares outstanding: 2,749,678
Market Cap: $25.5 million
Net cash: $4.2 million
P/B (mrq): 1.40
P/E (ttm): 10.88
EV/EBIT (ttm): 5.65

Valuation

Jewett-Cameron is a pretty straightforward business to understand. They operate four segments: industrial wood products; lawn, garden, pet and other; seed processing and sales, and industrial tools and clamps. The lawn, garden and pet segment is by far the biggest and accounts for almost 80% of revenue. The company writes in their latest 10-K that this segment is less sensitive to downturns in the US economy than the market for new home construction. While that might be true the company’s revenue dropped significantly in 2009 and has never really recovered since. But thanks to lower expenses operating profit is back to roughly the same levels as before. See the table below for some historical financials:

Historical financials Jewett-Cameron

The favorable impact of the shrinking share count is clearly visible when we look at earnings per share. Despite little progress in the business itself earnings per share have almost doubled compared to 2008. When we look at the development of the revenue numbers it’s also clear why the stock has been a poor performer for the past three quarters. Revenue is almost back to the 2009 level, and it now appears doubtful that this company can grow at a meaningful rate in the future.

Because of that I think the most appropriate valuation is to simply take the average operating profit from the past 5 years, apply the average tax rate, throw a 10x multiple on it and adjust for the cash held by the company. This generates the following picture:

Jewett-Cameron valuation

As is visible this valuation indicates that the company is trading at roughly fair value, and the implication is of course that the share repurchases aren’t generating an above average return on capital. It’s in my opinion still an excellent use of cash. Buying your own stock at a 10x multiple basically means that you are generating a 10% return on your money. That’s a lot better than having it linger in a bank account like so many other companies are doing.

Conclusion

Jewett-Cameron is a very interesting company, but unfortunately not very cheap and that significantly reduces the value that is created by buying back shares. Buying back fairly valued shares is in theory a neutral transaction, except that it is usually better than a lot of alternatives (hoarding cash, growth acquisitions and dividends depending on tax situation).

Luckily Jewett-Cameron is not expensive either, and at the current prices it will probably generate a fair return for shareholders. Perhaps that it could be a great idea when you have some specific opinion on how the housing market in the US will develop, and how that will impact Jewett-Cameron. But that’s not a prediction I want to make or can make, and since there is not much of a margin of safety at current prices I’m staying at the sidelines.

Disclosure

No position in Jewett-Cameron Trading at the time of writing.

Amira Nature Foods, a good short?

7 Replies

While browsing on VIC I noticed that apparently a couple of short write-ups on Amira Nature Foods (ANFI) were removed from the site. I assume this was done because the company threatened VIC with legal action. This looked like a huge red flag to me, so I decided to do some due diligence to figure out if Amira Nature Foods is indeed a good short.

The great thing about researching a short thesis is that usually the shorts do a good job of explaining the short case, their sources and their reasoning behind their idea. A successful short is path dependent: you might not make any money even if the market agrees with you at some point in the future. So they have a good reason to present a compelling thesis. Unfortunately the material on VIC has been removed, but I’am guessing that the majority of the thesis is captured in this recent article on Seeking Alpha. To summarize the concerns:

  1. Low earnings quality. Free cash flow is consistently negative while earnings are positive, and the amount of cash taxes paid is lower than the reported tax expense.
  2. Not enough money for growth capex given negative free cash flow.
  3. Financials reported to SEC don’t match those reported to local authorities.
  4. Valuation very high compared to comparables listed in India.
  5. Company could be hiding potential related party transactions.

Earnings quality

I personally think that this is a pretty weak argument. It’s not weird that a rapidly growing company produces negative free cash flow: it’s actually positive if they can immediately reinvest the cash they receive in growing the business! What’s perhaps a bit weird is that the amount of money spent on new PP&E is very low. Inventories are growing rapidly, and so are their receivables. But there is a logical explanation for the growth in inventories, and the growth in inventories and receivables are not out of line with the growth in revenue.

A lot of money is invested in their inventory because Amira sells basmati rice. This type of rice needs to age approximately a year before it is sold: so a big part of what they do doesn’t require a significant amount of PP&E. It just requires time and a large inventory.

As a side note: the design of the packaging is pretty fancy. I can see how selling this for premium prices could be a good business:

Amira basmati rice

The relative low amount of cash taxes paid compared to the reported tax expense could also be a red flag, but what the author in SA article is missing is that the company is reporting various items outside the income statement as part of other comprehensive income. The losses reported here partially offset the taxes reported on the income statement.

Not enough capital?

If the reported revenues and earnings are correct this is really a luxury problem. Given the growing revenues and earnings they could probably raise additional debt (or maybe equity) if they need more capital. They could also start to generate free cash flow as soon as growth slows down. With $46 million in cash at the bank and $70 million in receivables I don’t think that there is an emergency liquidity issue. Their net debt is now lower than it has been the past five years.

Mismatch between SEC financials and Indian financials

I think this one has a pretty obvious explanation. Amira has various subsidiaries operating all over the world. The financials reported to the Indian authorities are most likely only for the Indian entity while the SEC financials include the consolidated results of all subsidiaries.

High valuation

Compared to other Indian (basmati) rice companies Amira looks expensive, but when you look at the growth in revenues and earnings it doesn’t look that crazy. Comparing a big and slow growing company with a small and rapidly growing company doesn’t make a whole lot of sense. It does raise the question what it exactly is that Amira is doing that is so successful. To be clear: I don’t really know, but if the financials can be trusted the valuation argument doesn’t look very convincing.

Related party transactions

I think this item is potentially the biggest issue. If the reported financials are correct I don’t think Amira Nature Foods is a good short, but if revenue and income growth have been overstated the downside could be huge. The screenshots of the Karam website (see SA article) are troubling, but there could be an innocent explanation. The foreign subsidiaries of Amira haven’t been in existence for a long time. The middle east entity was for example not founded until 2009. The Karam website doesn’t exactly look like it is often updated, so it’s perfectly possible that this is a related party that used to do business with Amira in the past, but isn’t doing this anymore.

Using the Wayback Machine we can see that Karam’s claim of being the sole representative of Amira Foods in the middle east dates back to at least early 2008 and that since then the page wasn’t updated until it was recently deleted.

Conclusion

Maybe the VIC write-ups covered something that I wasn’t able to find online, but in my opinion the short case for Amira Nature Foods is weak. It seems that there is a plausible explanation for almost every red flag. Those explanations could of course turn out to be wrong, but I don’t see the proverbial smoking gun in the evidence. To be clear: there is absolutely no way that I would consider going long this stock. It’s simply too expensive for me and I don’t understand what’s exactly driving their growth and how sustainable it is.

Disclosure

No position in Amira Nature foods