Category Archives: Research

Clark Inc: the Canadian Icahn at a discount?

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

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?

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?

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

More from Singapore: Nam Lee Pressed Metal Industries

Another name in the boring and cheap category from Singapore is Nam Lee Pressed Metal Industries. It’s a family business that designs and manufacture metal products for the housing industry and aluminium frames for container refrigeration units. The company is headquartered in Singapore but also has production facilities in Malaysia, Indonesia and China. As usual I’ll start with some quick valuation metrics:

Last price (Sep 27, 2013): 0.30 SGD
Shares outstanding: 241,159,000
Market cap: 72.3M SGD (57.4M USD)
Free float: 41%
P/B (mrq): 0.63x
P/E (ttm): 7.4x
EV/EBIT (ttm): 2.9x

Financials

The metric that looks the best is the EV/EBIT ratio because the company has a large cash position. If we count a recent bond investment also as a cash equivalent the company has 16 cents per share in cash while the shares trade at 30 cents. The net cash position has been depressing their return on equity, but it is on average still a very respectable 11% since 2007. It’s good to see that even in 2009 when revenue was down sharp it was still profitable:

Historical financials Nam Lee Pressed MetalsThe historical financials paint the picture of a solid, but not a spectacular business. The quality of their reported earnings seems to be fine based on how much is converted to cash flow. The FCF for the TTM doesn’t look good, but I think it’s probably a positive. The low free cash flow is mainly caused by increased investments in working capital (inventory and account receivables) due to higher sales and projects picking up pace. Unfortunately the gross margin is down significantly compared to last year, but not outside the historical range. No immediate reason for panic.

What’s also positive is that the company has been paying a decent dividend that averages 33% of net income. I think they could return a bit more money to shareholders given how much cash they have, but you can also see in the recent results how quickly cash can disappear when more working capital is required. The family probably prefers to finance the business conservatively and keeping some cash on hand is totally fine with me.

Valuation

The valuation of a stable manufacturing company is straightforward, and the main question is what you think the cost of capital of this firm should be. I think something around 10% is reasonable, maybe a bit more,  which would imply the firm is worth approximately 10 times earnings plus the value of the non operating assets. Net income for the TTM is 9.7M SGD while the 7 year average is 9.1M SGD. This would imply a valuation around 130M SGD, or almost two times the current market cap.

Insiders

Nam Lee Pressed Metal was founded by the Yong family in 1975 and three of six members of the board are family members who have been with the company since it’s inception. The family still owns almost 60% of the stock and they appear to be shareholder friendly by paying out a decent percentage of income as dividends. It’s of course a question what the company is exactly going to do with the large amount of cash on the balance sheet, but insiders certainly have the right incentive given how much of the company they own. What’s a slight positive is that the high cash balance is a recent phenomenon.

Risks

One specific risk that the company faces that deserves some discussion is the following:

A major customer accounts for a substantial portion of our revenue. We are therefore dependent, to certain extent, on this major customer, as any cancellation of its sales and purchases would have an impact on our operations. Although we have long-term contract with our major customer, it may alter its present arrangements with us to our disadvantage, which would in turn have an impact on our operating income, business and financial position and consequently, our operating profits may, to a material extent, be adversely affected.

The big customer (I’m guessing it’s Carrier) buys aluminium frames for container refrigeration units and is responsible for more than 50% of revenue:

In the current financial year, revenue from two major customers amounted to $89 million (2011: $114 million) arising from sales by the aluminium segment and $11 million (2011: $15 million) arising from sales by the aluminium and mild steel segments respectively.

Being dependent on one customer for a big part of your revenue is a major risk risk, but the company does have a few things going for it. It has a long relation with this customer, so apparently both parties are happy with the status quo. The oldest annual report I could find online was from 2008 and since then nothing has really changed. Nam Lee is also the only worldwide third-party manufacturer of aluminium frames that is used by this customer. It’s not the only supplier, but the other suppliers are related parties that are located in the US.

Conclusion

Nam Lee Pressed Metal Industries is a boring but solid business. Their customer concentration is the only major risk factor I see, but given the amount of cash on the balance sheet the downside is somewhat limited. I also think that there is no real reason to believe that this will become a problem anytime soon given how it hasn’t been a problem in the past. In the end this idea is very similar to the earlier discussed Spindex Industries: both are cash rich businesses with high insider ownership, decent returns on equity and a nice dividend yield. If I would have a lot of cash laying around I would probably buy some shares.

Disclosure

No position in Nam Lee Pressed Metal Industries