Saturday, 19 November 2016

Thoughts on the week ended November 18, Canopy Growth, Newfoundland Capital, Bond Rout, Fairfax, and Acasta Enterprises (again)

Well, it's official. The week ended November 18th was, without a doubt, the week that Canadian speculators in marijuana stocks lost their collective minds.

First off, Canopy Growth:

This reminds me of my days on the trading floor at CIBC WM during 1999, where all someone would need to do is utter the words "internet", and any stock with an internet theme would double (or triple) in a week.

Well this week, Canopy got up to a market cap equivalent of almost $2B intraday on the prospect of being a winner in the political legalization sweepstakes. Funnily enough, the same day Canopy almost reached $2B, it closed red, and reversed almost $700M in market cap in less than 3 trading hours. None of this matters to me as this is not my arena to play in. I can only observe and feel for the poor souls that paid close to $18 on the day, only to watch $18 become $10 before the day was out. No doubt the move up to $18 must have been a short squeeze as liquidity disappeared.

I've been thinking about the numbers underpinning this move. Year to date, sales have totalled $15M, but have grown close to 400% on a year to year basis. Fiscal 2016 sales will probably come in somewhere between $25M to $35M, so on a market cap of $2B, this works out to roughly 67x sales, Bulls will argue that the velocity of price is completely justified given the company's opportunity, but me being somewhat grounded, thinks that this is rubbish.

There have been varying reports over the last few weeks pegging the North American marijuana market at between $5B & $10B, so assuming $5B, at a $2B market cap, Canopy investors were pricing in (crudely) $2B/$5B = 40% of the market, and assuming $10B, $2B/$10B = 20% of the market, on existing annualized sales of $30M?

Out of curiosity, I wanted to find something to compare the growth story to, so I figured why not look at Craft Beer market share over time.

There's an interesting piece from Marketwach on U.S. beer industry market share, link here, which pegged beer industry sales at just over $100B in 2015. Craft beer accounted for about 21% of the dollar value, according to this brewer's association article, link here.  What's interesting about the brewer's association article is the infographic on growth, link here, and reproduced below.






























































































Thinking about the growth here, unit volume has grown at close to 18% per year since 2009, and volume share has increased from 5.7% to 12.2% since 2011, at close to 20% growth per year. Now, none of this growth comes anywhere close to Canopy's 400% year/year growth, but the funny thing about growth that seems to get lost on the bull case is that it diminishes incrementally the larger the comparative base period gets.

In defence to the bulls, the market dynamics are different: Craft Beer filled (and continues to fill) a niche void not enjoyed by the incumbent producers (at least historically), and in this respect, Canopy may well have a prime mover advantage in uncharted territory, but my guess is that the barriers to entry on demonstration of abnormal economic profits will only attract more players (eventually), which will drive economic profits down. From the looks of it, Health Canada continues to actively process applications, see link here.

So, while a prime mover advantage may exist, I wonder how long it will be sustainable for in the absence of enforceable barriers to entry.  For curiosity's sake, Boston Beer, which has grown sales from $30M in 1991 to just under $1B in 2015 (good for 16% CAGR over 24 years) sports an EV of $2B on sales of $2B, and had about a 2% market share of the total $100B US beer market. If under perfect competition, marijuana production and sales "eventually" mirror the economics of the craft beer market, I wonder if it would be fair to estimate that a 2% share of a $10B  market equates to a market cap of $200M at the high end, about 80% below current?

One final observation, I couldn't help but observe the following disclosure in the latest quarterly report regarding per gram pricing: Is it just me, or is this going the wrong way on the way up the supposed exponential growth curve?


















I wouldn't be surprised if this all ends badly, but I've been wrong before (more than once).

Next up, Newfoundland Capital

While observing the temporary insanity at work in Canopy, I happened to read a research report published on Cogeco Inc. where an analyst made a case for upgrading the company based on the discount between Cogeco Inc. and Cogeco Communications Inc. being too wide. I thought, novel idea, but what if Cogeco Communications Inc. itself is overvalued? This got me thinking about cable and broadcasting, and I stumbled onto Newfoundland Capital Corp Ltd., a tiny little company no one has likely heard of or cares about, trading at 9x earnings with a market cap of $253M and an EV of $400M. They are an operator of radio stations primarily in Eastern Canada, although they've recently branched out to Ontario and B.C.

I read their 2015 annual report and was interested to discover that in 2014, they purchased the shares of five companies which operated two Toronto radio stations and five Vancouver radio stations for around $111M (net). Out of the $111M, $109M was allocated to broadcast licenses. Prior to the acquisition, existing broadcast licenses for all of the company's other radio stations were carried at $162M, so the total of all old broadcast licenses of $162M + total new broadcast licenses of $11M add up to $272M carrying value, vs. a market cap of $253M. Either the market thinks radio broadcasting is going the way of the do-do, or I've stumbled onto something here. Here are my calculations on historical ROIC
















NCC has grown its revenue (100% radio ad spots) at close to a 6% compound clip since 2006, and  its operating income at 16% compound over the same period. I take this to mean that the company is an efficient operator.

The company took on additional debt to purchase the Toronto and Vancouver stations, which has reduced ROIC since 2014, but from my research, the company generates close to $30M in free cash flow per year, and has been using free cash to repay debt and buy back shares. If NOPAT stays constant and acquisition debt continues to get repaid, ROIC should return to 2012/2013 levels. I think this is part of the investment thesis here, that ROIC should improve vs. current.

The closest comparable I can think of is Corus which trades at an 11x EV/EBITDA multiple vs. Newfoundland Capital at 8x EV/EBITDA. I'm assuming that the spread is due to tight control of the float &/or oversight in the market. At 11x EV/EBITDA, NCC would fetch  $49.6M  (ttm) x 11 = $546M, or +36% from current. Maybe this isn't such a stretch, given that the balance sheet is cleaner relative to Corus. Maybe NCC is an acquisition target for a larger media conglomerate looking to buy established radio operations cheaply? This is all speculation on my part.

When Canopy hit close to $2B intraday on Wednesday, I couldn't stop thinking that momentarily, it was worth 5x NCC on a literal fraction of NCC's sales, but obviously, NCC ain't growing at 400% per year. On the other hand, NCC does seem to have barriers to entry in the way of broadcast licenses which aren't issued nearly as generously as marijuana grow up licenses, but then again, what do I know.

In terms of potential growth runway, I offer the following infographic from the 2015 AIF:


















While not as sexy or alluring as a company on the medical marijuana exponential growth breakthrough frontier, I offer the suggestion that NCC, acting as the only pure play public radio broadcast company in Canada, seems to have demonstrated strong operational capabilities in an industry where the majority of broadcast licenses are still held outside of the big four, so perhaps NCC's value proposition is to continue acquiring existing licenses at reasonable prices, below current market multiples...

With reference to the July 2014 acquisition report, the gross purchase price of the shares acquired was $111.9M (net purchase price was $109M).  Here's the balance sheet at the time of the purchase:






















It appears that NCC paid just around 1x book for the acquired assets.

The annualized EBITDA I calculated based on the period from July 5, 2013 to March 30, 2014 was just under $14M, so this works out to $112M / $14 = 8x EV/EBITDA, and the free cash generated during the same period was $14.7M as stated over the 8 month period, which works out to $22M annualized, or a multiple of $112M / $22M = 5x EV/FCF.

Full disclosure, I bought shares this week at $9.90 and intend to hold for some time.

Bond Rout vs. Fairfax

I had no idea that Fairfax was a fixture in the fixed income universe. Here's TLT vs. FFH over the last six months. Eerily similar:





















I'm assuming that this short term correlation means a few things in the minds of investors:

  • Investors who previously thought Fairfax was a "market crash hedge" (one of the most ridiculous notions I have ever heard btw) have woken up and realized it actually isn't
  • Investors don't believe that the deflation hedges will have any chance of working given the change in regime in the US post Trump. The notional value of the deflation hedges was around $109B at last check, but as the deflation bet basically seems to be deflation puts, at risk are the premiums paid of around $600M.  If Mr. Watsa is wrong, he loses the premium. The way the stock has acted over the last month, you would think that investors believe there's more at risk than just the premiums paid.  With reference to this, there's a great article written by the Brooklyn Investor on this bet from a few years ago, link here. Suffice it to say, if we ain't getting deflation, TLT seems to be suggesting we're getting inflation, so the two have moved in lockstep recently by virtue of Fairfax turning itself into a deflation payoff machine 
  • Maybe investors are waking up to the notion that hedging 100% of the equity portfolio over the last seven years and changing your tune in one week hasn't created the "crash hedge" value they originally thought was the case (I know, this sounds ridiculous)
The contrarian in me thinks that as sheep sell based on the above and re-price Fairfax based on no crash hedge and deflation bet in the toilet (for now - there's still +5 years to maturity left), there's still an insurance company buried underneath all of this, and rising yields have lit a fire under other insurers, so at some point, once the old "crash hedge" guard finish exiting and go buy marijuana stocks, there will be opportunity for value investors here.


Finally, Acasta Enterprises (again)

I wrote about Acasta last week and I've had time to digest the +500 page prospectus (while juggling regular work and three kids) and I made some further notes.

First off, the market hasn't really moved in respect of the common shares, which still sit at $10. I believe this is due to an additional share offering to be done at $10 in order to complete the acquisitions. The deal is also subject to vote and approval in early December, but if the founders have voting control, I can't see the deal being opposed (but anything is possible). 

Here's an excerpt from the prospectus on management's estimate of post closing NAV:





















So what are they buying exactly?
  1. Two consumer staples companies (one in beauty & personal care, the other in laundry care & dish-washing products), Apollo & Jempak
  2. An aviation finance company, Stellwagen (an Irish domiciled company)
I believe that the narrative behind the consumer staples value proposition is that the industry is fragmented and offers a chance for an efficient operator/consolidator to create value over time, and the value proposition behind the aviation finance company is that there is an opportunity as a result of lenders exiting the space during and after the 2008/2009 crisis, and fleet management/finance is pegged to grow.

So really, this becomes a bet that Mr. Melman will be able to create significant value over time starting with these three acquisitions as an initial platform for growth and deal flow.  

What are they paying in terms of multiples? My rough notes are below, using 2016 annualized data from the prospectus:



















These are rough calculations only. I tried to back into the 2016 pro-forma combined EBITDA of $60M per the prospectus, but I think this includes expected operating synergies post combination. In any case, at worst with no synergies, they seem to be paying 10x 2016 EBITDA, and with synergies, 8.5x EBITDA for the consumer staple platform. This compares with almost 15x for XLP the consumer staples sector fund for what it's worth.

The Stellwagen purchase seems to have been done at 8.8x EBITDA.

Proforma EBITDA per the prospectus is as follows:




















Annualizing, I get $164M, so at an EV of $1.2B post closing this works out to 7.3x (lower than the estimated 2016 purchase price multiples paid).

Full disclosure, I own both Class A units and warrants.

Saturday, 12 November 2016

Thoughts on the week ended November 11, Fortis , Fairfax and Acasta Enterprises

This week was a tumultuous week for dividend investors, despite the Dow hitting a new all time high. Under the surface, there was a noticeable rotation out of income "proxies" like REIT's, consumer defensive, and utility stocks. I also noticed rotation out of high beta / tech favourites, like Google, Facebook, and Amazon.

Anything that had done exceptionally well this year due to yield or momentum chase got sold this week and anything that could potentially benefit from the Trump electorate (and by extension, anything that would benefit from higher rates, elimination of Obama-care, and continued deficit spending) got bought (banks, insurance, E&C contractors, etc.).

On the subject of this theme, let's look at Fortis. Long an institutional and retail dividend favourite, here's Fortis this week:



























Now, a one week move doesn't really do justice to a long term trend, so here's Fortis over the last 10 years:



























Putting things in perspective, this last week's performance looks like a blip. The problem I have with charts is that they only capture what has happened historically. To some extent, they offer clues as to what may happen going forward, but clues are not research, they are at best suggestions as to possible courses of price action through which experienced traders assign probabilities in order to make decisions. Whether those decisions ultimately lead to profits is a function of how good the trader is. In the case of the average investor, none of this should really matter, but I've digressed.

In order to really understand Fortis (or by extension, any regulated utility), I think it's important to understand how Fortis operates its business, and how management allocates capital in order to earn returns on invested capital.

Looking simply at Fortis as a "stalwart/dependable" dividend payer only tells a fraction of the story. The company's ability to pay dividends is a function of how well management allocates capital, and historically, management has allocated capital with a lot of help from accommodating capital markets.

First, a comment on return on invested capital. As noted in my previous post on Great Canadian Gaming, I have begun tabulating a database of incremental ROIC by companies I am interested in. I noticed something really interesting as I worked my way through the universe of investable Canadian companies, which I'll demonstrate by example below:

Here's Great Canadian Gaming again:












And here's Fortis:













As I've been comparing ROIC between companies with different capital structures, I noticed that ROIC for non utilities was significantly higher than ROIC for Fortis. Intuitively, this makes sense. Fortis has massive investments in PPE, which is fundamental to the company's ongoing operations. Put another way, one could make a reasonable prediction that investment in PPE on a similar scale will continue indefinitely. The company is committed to continuously maintain and/or upgrade its grids / capacity etc. in order to operate.

My estimated ROIC at 5% x a 150% reinvestment rate tells me that on balance, the company has capx in excess of operating cash flow. The difference between op cf and capx needs is funded by access to capital markets, either by virtue of issuing debt or equity.

For anyone interested, in order to estimate my reinvestment rate, I took average capx over the last 3 years, and divided this by average operating cash flow over the same period. For Fortis, capx / op cf worked out to in excess of 150% reinvestment, and this again, makes intuitive sense to me from the standpoint of understanding what a utility does. It constantly reinvests in capx over and above it's operating cash flows. My theoretical value compounding rate then becomes a function of ROIC x reinvestment rate. I think this result is synonymous with the empirical concept of estimating "g" in traditional DDM models. The dividend growth rate, "g" in conventional introductory finance is reinvestment x ROE, derived by virtue of solving for g in the formula, ROE = g  / (1-payout).

In my backwards (or forwards) way of thinking, I've substituted ROIC for ROE in order to solve for "g", where "g" is an estimate of a value compounding rate.

Obviously, "g" under either model isn't static, as required reinvestment changes over a company's life cycle.

My question here is, is a +150% reinvestment rate observation an outlier? By assuming reinvestment in excess of operating cash flows, I'm making a pretty significant generalization about the nature of utilities. There's an easy way to test this result, and that is to observe the ratio of capx to operating cash flow over time. Here's Fortis, courtesy of Morningstar:



















Generally speaking, capx has exceeded operating cash flow every year since 2006, and the ratio of capx : op cash flow has ranged in scale from 2.15 : 1 to 1.1 to 1 over the last 10 years. Again, this is a general observation and intuitively, it makes sense as the company has needed to constantly upgrade PPE in order to upgrade and maintain its productive asset base in order transmit & deliver electricity &/or gas.

Is this result problematic in its own? Probably not, but it makes sense for anyone interested in buying the stock simply because it pays a dividend to understand that in order for the company to continue paying dividends, it must a) be able to grow operating cash flows (subject to rate regulation constraints) and b) continue to have unrestricted access to accommodating capital markets in order to balance a) with indefinite capx constraints.

Here's a quick look at just how accommodating capital markets have been in terms of bridging the gap between operating cash flow and capx:



















Roughly, the company has raised over $6B in either debt or equity issuances since 2011 in order to upgrade &/or maintain PPE and to make acquisitions. Not included in the above is the debt raised in order to acquire ITC Holdings this year, roughly $2B US.

So far, I've only discussed ROIC, but what about WACC? I think this is the missing component in understanding Fortis (or by extension, any regulated utility).

As I've calculated above, ROIC has averaged around 5% incrementally since 1996, and it appears that the value compounding proposition is a function of reinvestment driving growth. In reinvesting in excess of 100% of its operating cash flow, Fortis has been able to compound at 7.5% annually. So what about WACC?

From my readings along my investing journey thus far, a company can only create value over time if it earns an ROIC in excess of it's WACC. I find the concept of WACC tough to get my head around, simply because it's loaded with estimation. I am not in any way, shape or form, a finance maven, nor am I able to offer any expertise in terms of attempting to estimate beta, Rf, or the spread between Rm and Rf. The best I can offer is a point in time look at what WACC may (or may not be) today based on currently accepted parameters in the market.

Simply speaking, WACC is an estimation of weighted avg cost of capital, and my best (lazy) attempt to calculate Fortis' WACC is as follows:

% debt = $12.5B / ($12.5B + $10.3B) = 55%
% equity = (1 - 55%) = 45%

AT Cost of debt = (1-.28) x $293M x 2 / $12.5 = 3.4%

Cost of lazy equity:

The laziest estimation I can come up with is to simply use the incremental ROIC as the cost of equity. In this case, I use 5%.

The empirical estimation uses Capm as follows:

Re = Rf + Beta x (Rm - Rf)

For Rf, I'm going to borrow from Professor Aswath Damodaran and use a current point in time estimate of the North American risk free rate of 2%, and similarly, for the equity risk premium for Canada, I'm going to use Canada's equity risk premium of 6.25% (link here). Arguably, risk free rates are close to zero, but I don't feel comfortable modelling zero as this is a function of QE in my opinion and may not be sustainable over time.

For Beta I'm going to borrow from Professor Aswath Damodaran and use the beta for utilities as a group (currently) of .55 (link here)

Re = 2% + .55 x (6.25%) = 5.4%, pretty close to ROIC.

At 0%, Re = 0% + .55 x (8.25%) = 4.5%

My hybrid lazy WACC(2%) is therefore = 55% x 3.4% + 45% x 5% = 4.1%, and WACC(0%) is therefore = 55% x 3.4% + 45% x 4.5% = 3.9%

Now here's where analyzing Fortis gets really interesting. Recall my comment that a company can only create value over time if it earns an ROIC in excess of it's WACC.

Well, here's Fortis' spread based on Rf at 2%:

ROIC - WACC(2%) = 5% - 4.1% = .9% economic spread

And here's Fortis' spread based on Rf at 0%:

ROIC - WACC(0%) = 5% - 3.9% = 1.1% economic spread

One more piece of the puzzle. Given the above results, i.e., accepting that the economic spread is positive but just marginally equal to 1%, why has Fortis commanded a premium valuation over time?

Here's Fortis' multiple over time as compared to the S&P/TSX:


















In every year with the exception of 2009, Fortis has traded at a premium multiple to the market. One possible explanation here is that because Fortis is essentially a regulated monopoly, it has been awarded a premium valuation by investors over time.

I personally think it's odd that investors would pay upwards of 20x earnings for a company with an economic spread between ROIC and WACC of 1%, but maybe the thinking here is that this 1% spread is sustainable and impenetrable by virtue of the company's monopoly status over time.

This is pure speculation on my part, but part of me believes that the most logical explanation for this:




























Can only be due to this:















As yields have generally plummeted over time, the logical beneficiaries are levered entities such as utilities, because in theory, as yields move down, WACC moves down (assuming some part of the existing capital structure is floating), and the spread between ROIC and WACC increases. Now, a 1% spread ain't much, but a movement in spreads from .5% to 1%, x leverage, well, intuitively, this is a recipe for higher valuations.

Now here's where things get interesting, and to close off on Fortis, I'm going to use an excerpt from Professor Aswath Damodaran's blog from last week (link here):

"That is not to say that I am sanguine about low interest rates. The low growth and low inflation that these numbers signal are having their effect on companies. Real investment has declined, cash flows to investors (in dividends and buybacks) have increased and cash balances have surged. The increase in debt at companies will not only increase default risk but make these companies more sensitive to macro economic shifts, with more distress and default coming in the next downturn. Finally, to the extent that central banks send signals about the future, the desperation that is being signaled by their policies does not evoke much confidence in them."

Could the recent spike in yields (globally) be the start of spread compression impacting utilities? If so, there could be a lot more pain in store for Fortis and the like.

Onto Fairfax

I'm not sure if anyone has had time to digest the news this week reporting that Fairfax has removed 50% of it's equity hedge book. Here's a link to the news release courtesy of the Globe and Mail.

I find this a fascinating about face, especially considered Mr. Watsa's bearish stance since 2010! By my estimation, he's run an almost 100% hedge book on his common stock portfolio for almost 7 years now, and during one of the most ridiculously volatile weeks in recent history (the Dow has rallied close to 2000 points since the Tuesday night post election lows), Watsa reports taking off 50% of the hedge book?  How is this not capitulation on a massive scale?

I did some quick and dirty math using the reported #'s from the 12/31/15 annual report.

Here's an excerpt on the hedge book:



























By my read, he added another $1B in notional shorts during the first few weeks of 2016 (talk about painful).

Here's note 24 from the 2015 annual report:


























Prior to the news release, he was short 112% of the fair value of the equity holdings, so assuming $6.7B at the end of 2015 + whatever return his equity holdings have generated YTD during 2016 (let’s use SPY and assume 7% YTD), he’d have been short $6.7Bx 1.07 x 112% = $8B notional?

The majority of the weighting was in individual equity and Russell 2000 swaps.  He must have gone into the market this week and covered  a combination of $4B notional total return swaps and individual shorts on a +2,000 point move against?

Utterly fascinating. Now that the last big bear has thrown in the towel, the market can really crash.

Onto Acasta Enterprises

This is a little known Canadian SPAC (blank cheque company) run by Mr. Anthony Melman, previously second in command at Onex. Acasta went public last year and raised close to $250M. I've owned units in the accounts I manage since the IPO, and my educated guess was that Mr. Melman (and the who's who of the executive team) would end up doing something exceptionally interesting in the future. I've pretty much ignored the units as they've done nothing since I bought them. I figured that owning units is akin to owning a call option with limited downside (if no strategic acquisition is done within a certain time frame, the units will get redeemed at close to par, and if a strategic acquisition is done, well, enjoy the ride).

Well, this week Acasta announced two strategic acquisitions and a new direction for the company. Basically, my read is that Acasta is going to be run like a mini Onex.

Here's an interesting excerpt from the news release concerning the acquired businesses and new direction, link here:























The units didn't do much this week, they only ended up around $.10 (some poor schmuck paid $11.80 on the open after the halt trade) but what drew me to the release was the estimated post closing NAV estimate and the stated price hurdle increase of up to $13-$15. There are lock up provisions in the release stipulating that the shares must reach $12 before founder shares can be sold, and the founders are taking on a significant amount of remuneration in the form of shares. Hopefully, this means that management are all aligned with creating value over time.

One last interesting tidbit: there are warrants outstanding with an exercise price of $11.50 and a 5 year life post approved strategic acquisition. These came alive this week, and I bought some, despite the stock only trading marginally above par.

I ran a simulation as follows using 50% expected volatility, a 5 year time to expiry, and a strike price of $11.50. Here are the results with stock price at $10:



















Here are the results with stock price at $13:

















It will be interesting to see how this all unfolds.





Thursday, 10 November 2016

Revisiting Great Canadian Gaming: Lessons on Capital Allocation

Thought I would revisit some preliminary thoughts I had on Great Canadian Gaming. I first wrote about the company back in January 2016. My initial post is here.

At the time, I had purchased $5K face value of the company's July 2022 6.625% bonds for par. Not a bad idea in hindsight as the bonds have rallied modestly to 105 since the time of my initial purchase and I'm still collecting 6.625% in a tax deferred account. As the bonds will mature at par, I'm going to ignore the temporary capital appreciation aspect of my purchase and just focus on a 6.625% YTM if I hold through maturity. Again, not bad, but not great.

Here's the problem with my idea: Back in January, I did what I thought was a pretty thorough analysis of the company's prospects, but in the context of continuing to progress (and hopefully evolve) in my investing journey, I realize now that what I did was analyze the company's runway without realizing it (more on this later).

Here's what I wrote:

"On Jan 11, 2016, GC announced the closing of a deal to operate casinos / facilities in Ontario. The company had previously disclosed that it was in the bidding for the license. 

So, I take this to mean the following:
  • The company is diversifying it's exposure base away from Western Canada to Ontario with this win.  Prior to the win, the Company had revenues of approximately $330M from existing facilities over the 9 months ended 09/30/15.  The OLG win gives them a minimum guaranteed fixed fee component of $15M per year (before Belleville is opened), and $24M thereafter, and a variable component = 70% of gross gaming revenue plus a fixed amount for approved capx + 100% of non-gaming revenue.  Even if the variable component is 0% (unlikely), the OLG piece is somewhere between $15M & $24M depending on when Belleville opens.
  • EBITDA would have been $16-$17M had the OLG win been in place for the year.  

I get EBIT of around $103M annualized (excluding new OLG).  EBITDA should be $103M + $28.9/9*12 = $38.5M, so EBITDA margin = ($103M +$38.5M) / $332.7/9*12 = 32%

Quick and dirty, taking the low end of their pro-forma range of $16M and applying overall company wide EBITDA margin, I get pro-forma revenues $16 / .32 = $50M.  $50 / $443M = 10% incrementally

My rough calculations only estimated incremental returns from existing casinos acquired and did not factor in the Belleville casino (under construction). As a result, I was too conservative (which was ok for the purposes of analyzing interest coverage at the time).

The company released results yesterday and reported that the recent acquisitions added around $26M in adjusted EBITDA for the 9 months ended Sep 30, 2016, on incremental revenue of $84.9M, a 30% EBITDA margin on incremental revenue (before Belleville)!

Let me digress quickly and discuss John Huber again. As I've pointed out previously, I am a big fan of reading John's blog, Base Hit Investing, and his various articles on the concept of return on invested capital. For anyone new to my blog, I highly suggest visiting Base Hit Investing and reading the series of articles John has written on ROIC. One of my favourite articles is here, which articulates the difference between legacy and reinvestment moats. 

Once you get through this article, there is a further article on calculating the returns on invested capital here, and a recent article articulating the differences between John Huber's methodology of calculating ROIC vs. Buffett's methodology, here, which is central to the direction I believe my thought process is taking me over time.

Buffett discussed a very simple approach to calculating ROIC in his 2007 shareholder letter using the example of See's Candy. Without going into huge detail (I will leave this for the curious reader), Buffett took incremental pretax income divided by incremental invested capital over time. Buffett's definition of invested capital is net PPE + net working capital in this example (a simplified method of measuring invested capital, but it worked for See's Candy).

Huber on the other hand, looks at invested capital from the financing side of the balance sheet. His approach is to take incremental NOPAT divided by incremental capital (Equity + Debt + off balance sheet leases - cash - goodwill).

For the most part, the two approaches should yield similar results, as the capital financing side of the balance sheet should lend itself to analysis of use (the equity + debt raised has been invested in net PPE + working capital over time). I'm oversimplifying as all businesses are different, but what the above approach has led me to do is to start developing a database analyzing all companies I'm interested in from both perspectives in an attempt to understand ROIC.  The flipside of course, is to compare ROIC to WACC in an attempt to determine the economic spread between the metrics.

Here's Great Canadian Gaming updated through yesterday (for simplicity, I took yesterday's 9 month reported results and annualized by /9x12












As can be seen, ROIC under both Buffett and Huber is pretty close, I take this to mean that I haven't made any egregious errors in calculating ROIC. The problem here is that ROIC is blended, it includes everything. What about ROIC on the newly acquired casinos?

For this, I'm going to take incremental EBITDA of $26M above and annualize this: I get $35M, on a purchase price of $94M per the 2015 audited financial statements. Out of the purchase price, $75M was allocated to land, building/leaseholds, and equipment, and the majority to building/leaseholds, so I'm going to assume a 30 year amortization period (roughly equivalent to tax amortization).

The OLG east bundle cost $47M, and out of this purchase price, $28M was allocated to property, plant and equipment. I'm going to assume a similar 30 year amortization period.

In total, I get ($75M + $28M) = $103M / 30 = $3.4M per year in incremental amortization, so say incremental EBIT of $31.6M. Borrowings didn't change significantly, but let's assume the purchases were financed with incremental borrowings of $103M x 6% = $6.2M in incremental interest per year.  I get pretax income of $25M on invested capital of $103M, or an ROIC of 25% incrementally. Interestingly, ROIC is in excess of my legacy calculated ROIC with respect to the newly acquired casinos (and this is before Belleville is completed!). 

Tying it all together

What I'm trying to come up with here is a feedback loop mechanism in an attempt to evaluate my initial analysis in January. For this I need to ask the following questions: 1) Was my January analysis correct (for the most part), and 2) Did I make the best use of my analysis in order to make the correct investing decision (i.e., was it correct of me to buy the debt instead of the equity).

1) Was my January analysis correct:

Yes, I believe I was on the right track. Without knowing it, I had the beginnings of attempting to evaluate potential growth runway by virtue of analyzing what the new OLG east bundle might have earned going forward. A simple approach here could have been taking the purchase price of the net assets acquired and estimating pretax income or NOPAT by using historical  incremental ROIC as calculated above.

From the January 11 press release:


























Better yet, the company provided ttm EBITDA of $16M-$17M, so on a purchase price of $51.3M + working capital of $12.3M for the first casino out of the bundle, the company basically purchased an annuity stream for 3.75x -3.95x TTM EBITDA.

At the time, the company was trading at around 7x TTM EBITDA in the market, so my conclusion here is that this was an exceptional demonstration of capital allocation buying incremental assets at 1/2 of the then current market EV:EBITDA multiple.

The total OLG purchase package ended up being $141M (pre-Bellevile), so using EBITDA of $16-$17M on the first casino purchase of $51.3M + working capital of $12.3M, I'm assuming that total expected EBITDA on the entire bundle would be 26% x $141M =  $37M, or almost 20% of 2015 EBITDA before Belleville was built!

All of a sudden, TTM EV: EBITDA 7x becomes 6x fwd EV:EBITDA factoring in expected earnings from OLG East, and this for a company which arguably has a pretty solid moat in terms of owning and operating casinos (casino licenses aren't just given away)!

Put another way, EBITDA : EV was around 16.67% at the beginning of January (1/6).

2) Did I make the best use of my analysis in order to make the correct investing decision (i.e., was it correct of me to buy the debt instead of the equity):

This is a more difficult question to answer (but easier to answer in hindsight). At no times were the bonds distressed. Even during the midst of the January swoon, the bonds traded at par. Buying the bonds at par was a secure way of locking in a 6.625% coupon for 6 years, but there was no prospect of capital appreciation.

The equity on the other hand, was being priced in the market at distressed levels, partly due to perception of the company's exposure to Western Canada, and the astute analyst (of which I was not) would have realized that even without OLG east acquisition, the existing casinos under operation were being valued at 7x EV:EBITDA. The same $5K invested in the equity at $16 would be worth $7,930 today, and I missed the idea because I don't believe I realized what I was analyzing in real time.

By buying the debt, I was securing a very nice 6.625% YTM. By buying the equity, I would be getting OLG East virtually for free.  I will chock this one up to experience.







Saturday, 1 October 2016

Third quarter update and reflections on the previous nine months

I'm going to address a few ideas in this post and reflect on my year to date thus far, including a snapshot of my own returns. I'm also thinking of starting an entirely new blog, as I don't believe that "building a stable dividend portfolio" really captures what I'm getting at personally.

I am still searching for an approach that suits my personality, and I continue to attempt to draw inspiration from great investors in order to conceptually refine my own approach.

I currently feel like I should be operating within the spectrum of the following possible approaches:

  1. Searching for cheap stocks in the context of Ben Graham's teachings,
  2. Searching for stocks that may not appear cheap currently, but which either have a potential legacy or reinvestment moat
  3. Searching for misunderstood stocks which fall somewhere between approaches 1. and 2. above
  4. Searching for special situations (spin-offs, merger/arbitrage, etc.)
  5. Searching for under-priced bonds relative to AAA rated bonds, and
  6. Being cognizant of risk inherent in approaches 1) through 5) above

Reflecting on the past 9 months, I have had a so-so year.  I calculated my returns through Friday's close and I have earned 4% on my assets under management (not including new capital contributions), calculated as follows:

  • AUM Jan 1 2016, $125k
  • AUM Sep 30, 2016, $150k
  • Capital contributions, $20k
  • Increase in AUM $5k (realized and unrealized gains + dividends and interest income received)

$5k/$125k = 4%

If I make no further investment decisions between now and end of December, it's pretty safe to say that I expect an annualized return of just over 5%, which isn't great, but isn't terrible either.

I also have to evaluate my performance in the context of distribution across the asset classes I own in the accounts I manage.  I've roughly averaged around 40-50% cash during the year and I hold held very little in the way of equities currently. I'm currently closer to 70% cash at present, looking to redeploy cash into workable ideas, which I'm not finding much of recently.

Relative to the S&P500 which has returned around 6% YTD (closer to 8% YTD including dividends), I'm under-performing by almost 200 BPS, although I hesitate to put too much credence into this comparison because my cash allocation throughout the year has impacted my returns. It's been a tough year for me in the sense that the market has hovered at or near all time highs for most of the year after March, and I'm extremely cautious about blindly chasing flavour of the day ideas. Remove Amazon, Apple, Facebook, and Alphabet, and I suspect that the S&P500 YTD return picture changes considerably.

I'm not going to bother comparing my performance to the S&P TSX because in my opinion, the index is irrelevant to me. I'm certainly not comfortable with a 1/3 speculative energy and materials weighting and 1/3 bank/financial concentration in my own assets under management, but for whatever reason, other investors are. I'm happy being the exception here.

My main problems with equities right now are as follows:
  • I haven't found many idea's which seem particularly cheap, especially after Feb 2016
  • Whatever I did buy in Jan/Feb is mostly gone (I sold on the way up)...and one of my regrets this year was exiting some really good ideas way too early (Children's Place, CST Brands, H&R REIT, and Information Services Corp to name a few)
  • My belief is that because equity markets are knocking up against all time highs, the most popular stocks are ridiculously overpriced and over owned. This leaves little in the way of Margin of Safety in chasing popular stocks at all time nosebleed highs (although my beliefs don't preclude stocks continuing higher)
  • Once again, the theme of "disruption" seems to have become accepted doctrine for paying, and justifying, silly prices for future growth (Amazon, Facebook, and Netflix come to mind). And this theme seems to have perpetuated over multiple years, which is perplexing to me
  • In the same way that the markets seemed manically depressed in February, they now seem stupidly euphoric.

All said, now is the time for me to sharpen my proverbial pen and refine my approach. I have to review what worked for me this year and sort out why things did or didn't work.

I have long been a proponent of actively scouring the daily 52 week lows for ideas, but 52 week lows aren't the only source of ideas. Usually, 52 week lows are made for a reason. A good friend of mine has drawn my attention to searching 13f HR's for new filings of interest. Sometimes, highly concentrated holdings by well established investors can be a source of great ideas.

I also have to revisit my analytical approach. My initial, arbitrary fcf/ wacc screen doesn't mean much unless wacc is compared to roic, in conjunction with an objective evaluation of potential growth runway.  While I've found some great ideas using my screen, I wonder whether the results were more a reflection of buying January 2016 lows vs. a result of thorough research supporting an investment thesis, a term another friend of mine has coined as "having an anchor". I believe that objectively analyzing a potential growth runway will help me steer clear of value traps (a few of which I've had the pleasure of owning).

So, on this concluding note, I've got much more work to do as my journey has really just begun.



Saturday, 3 September 2016

Bed Bath and Beyond, Serious Underperformance, Why? Part 2

In my previous post, I drew attention to relative under-performance in Bed Bath and Beyond (BBBY) vs. basically everything (this year), and wondered what the market might be inferring.

I'm going to attempt to answer this question with reference to John Huber's series of articles on ROIC over at Base Hit Investing.  If you haven't read these articles, I highly suggest you do.

There are two particularly powerful articles which I've read, and re-read, and re-read again which provide an amazing conceptual framework for understanding ROIC and identifying companies with moats.

The first article, entitled "Importance of ROIC: "Reinvestment" vs "Legacy" Moats, link here, articulates an approach to distinguishing between both types of moats, and the role ROIC plays in compounding returns over time. I've never really thought along these lines until recently, but I'd hazard a guess that any serious investor has likely has thought along these lines without knowing it.

The second article, entitled "Calculating the Return on Incremental Capital Investments, link here, articulates the math behind evaluating ROIC. Like any other point in time return parameter, ROIC cannot be evaluated just at a point. I believe it is most useful when evaluating returns over time.

The key takeaway from the first article is that a serious investor looking to compound returns abnormally needs to spend his/her time identifying companies with reinvestment moats. Simply put, a reinvestment moat allows a company to reinvest earnings at exceptionally high rates of return over time. This type of company likely has a durable competitive advantage combined with a long runway of growth.  One of my favourite observations from this article is as follows:

On the subject of "Judging the "Runway" to Reinvest:

"Many investors focus purely on growth rates driving up the valuation of a company growing at high rates even if the growth does not carry positive economics. The key to Reinvestment Moats is not the specific growth rate forecasted for next year, but instead having conviction that there is a very long runway and the competitive advantages that produce those high returns will remain or strengthen over time. Instead of focusing on next quarter or next year, the key is to step back and envision if this company can be 5x or 10x today's size in a decade or two? My guess is for 99% of businesses you will find that it is almost impossible to have that kind of conviction. That's fine, be patient and focus your energy on identifying the 1%."

Absolutely brilliant comment and a clue. My interpretation as applicable to me? Don't try to force ideas. Every single day there's a flurry of opinion surrounding everything ticking red/green by the mili-second. Most companies out there likely don't have reinvestment moats. And the ones that do? Well, the market has most likely priced the reinvestment moat in (think Amazon, Facebook, Google, etc.) Focus instead on a) identifying companies with possible moats, and b) distinguishing between legacy vs. reinvestment moats. Once a reinvestment moat is identified, conservatively envision how a company might be able to grow to 5x - 10x today's size in a decade.

The key takeaway from the second article is thinking forward. The act of calculating ROIC over time forces you to evaluate where a company is at in terms of likely future runway to reinvest. The author gives two examples, comparing Walmart (Legacy Moat) to Chipotle (Reinvestment Moat, well up until recently anyway).

I'm going to demonstrate my findings using Bed Bath and Beyond, and doing so, I hope to evaluate whether BBBY has any type of moat, and/or future runway to reinvest (source = company 10k's)





















Some overall observations:

I have split the periods evaluated into three distinct phases, as follows
  1. Hypergrowth: Growth from 34 stores to 396 stores between 92 and 2002. Hypergrowth was accompanied by > 100% reinvestment rates (as an aside, reinvestment rate = incremental capital invested / cumulative earnings over period). This was a function of expansion, as the company took on off balance sheet commitments (new store leases). Capitalizing the future commitments, you get a sense of the extent of growth. BBBY needed to commit to new leases as they expanded aggressively, and reinvested more than their cumulative net earnings in terms of future lease commitments. ROIC is around 9%, but value compounding return is 24% as the company grows.
  2. Steady Growth: Growth from 108 stores to 888 stores between 1997 and 2007. The steady growth phase was still accompanied by > 100% reinvestment rates, but the reinvestment was falling relative to the hypergrowth period as rate of new store growth decreased. I've highlighted the rate of decrease commencing in 2001. ROIC is around 14%, but value compounding return has dropped to 17% as company growth slows.
  3. Mature to no Growth: Growth from 888 stores to 1530 stores between 2007 and 2016. Here, the reinvestment rate has fallen to 27.5% vs. > 100% in the previous comparative periods. ROIC has dropped to around 9%, and value compounding return has dropped to 2.5% as the company matures
I think the clues here as to whether or not BBBY has any sort of moat (and accompanying opportunities for reinvestment) is a) the use of capital over the last decade, and b) the consistently low ROIC. In the context of John Huber's framework, management are sending a clear signal that there is a real dearth of reinvestment opportunities because they choosing not to redeploy capital into expansion any more. Instead, they are engaging in massive share buybacks.

Concluding Thoughts

Arguably, there is no legacy moat (and certainly no reinvestment moat) as the returns on capital are slowly eroding and there's nothing to prevent price competition from eroding margins going forward. It's doubtful there's a long runway of growth here. Back in 1992 however, a shrewd investor might have picked up on the growth potential of the big box housewares concept at the time the company only had 30 stores. At +1500 stores, and slowing rates of growth in terms new store openings, the likelihood of +3000 in a decade seems a stretch.

The counter argument is that the runway lies in either global / international expansion outside of the US as BBBY is predominantly US based, but this would be a huge about face from the company's established market.

Now I understand why BBBY is cheap.

Monday, 22 August 2016

Bed Bath and Beyond, Serious Underperformance, Why? Part 1

This will be a short initial post as I'm up north over the weekend and not near a computer.

Bed Bath and Beyond is intriguing for one simple reason, and that reason is, it appears cheap across a variety of conventionally accepted metrics, P/E, EV/EBITDA, P/S, P/FCF, etc. All metrics appear to be pointing in the same direction. Additionally, BBBY, scores highly on my pseudo Greenblatt screener, and has consistently scored highly in Greenblatt's own magicformulainvesting d-base.

So, when all valuation metrics point the same way and a stock seriously underperforms over a long enough time period to confound anyone relying on relative cheapness as an investment thesis, I wonder what's wrong. Maybe, just maybe, there's something more going on beneath the surface to allow the conditions of relative cheapness and relative underperfomance to perpetuate.

I suppose the contrarian view here is that BBBY should (in theory) close any relative valuation gap at some point, considering the furious rallies shares in other companies (deeply cyclical, and more recently, other retailers, etc.) demonstrating nowhere near BBBY's earnings power have enjoyed during 2016, while BBBY has basically done nothing.

I leave this initial post with a comparative performance chart of BBBY from the company's 2015 10k, illustrating the extent of underperformance over the last 5 years. The question I have is, what is the company going to do in order to invoke enough investor confidence to close this relative underperformance gap?











Tuesday, 16 August 2016

Follow up Comments on Canadian Shareowner Ranking Screener, and Gilead at Top Spot

I spent a good chunk of time over the weekend thinking about possible shortcomings in my Shareowner screener (which I'm certain are plentiful). I noted that Gilead was ranked #1 in May and August according to my pseudo Greenblatt ranking system, and I made a general comment, as follows:
  • The entire ranked universe really is a relative point in time snapshot vs. the comparable stocks in the universe, and should be viewed as a starting point for additional research. For example, as at August 11th, 2016, Gilead had the highest ranking relative to every other stock in the Shareowner universe. The ranking tells us a set of facts, but does not tell us why this set of facts exists at this point in time. The job of the investor is to determine why Gilead is relatively cheap comparably. Sometimes, top ranked stocks are cheap for a reason.
With this said, I wanted to look further into the Gilead story as there seems to be no shortage of proponents for buying the stock based on apparent cheapness relative to other large cap companies in the S&P500, and especially based on relative cheapness vs. other large cap biotech or pharmaceutical companies.

While I personally don't like using P/E, it is a widely accepted conventional measure of current market based valuation on the fly. My problem with P/E is that it's a point in time estimate only, and in my humble opinion, investors can end up deluding themselves by solely relying on P/E without going beyond why a P/E is relatively low (or high).

I am by no means an expert on the biotech or pharmaceutical space, but my layperson's opinion on attempting to make relative comparisons within the space/s based only on P/E is to first understand the cyclical nature of the drug life cycle. There's a great article I read over the weekend illustrating the drug life cycle, link here, source, Awesome Capital.





If one were to use the above table of statistical probabilities through phase transitions and concurrent changes in valuation in order to broadly visualize how a sample company's P/E would look during each phase, I would suggest the following (I've added my own "later phase" italicized bullet points at the end):

  • Pre-clinical to Phase 1, little to no earnings, high R&D, extremely high to undefined P/E
  • Phase 1 to Phase 2, little to no earnings, high R&D, extremely high to undefined P/E
  • Phase 2 to Phase 3, little to no earnings, high R&D, extremely high to undefined P/E
  • Phase 3 to NDA/BLA, little to no earnings, lower R&D, extremely high to undefined P/E
  • NDA/BLA to Market Approval, initial earnings, lower R&D, high P/E
  • Introduction of product to market, generating incremental cash flows, substantial earnings, low R&D, falling P/E
  • Maturation through patent expiry, product continues to generate incremental cash flows, declining earnings, rising R&D, stabilizing P/E
  • Patent expiry, generic competition, falling cash flows, declining earnings, rising R&D, rising to high P/E
The article also outlines the connection between big pharma and biotech, as follows, which I found fascinating, a strategy which Gilead, interestingly enough, pursued to a tee (see excerpt below)






So here was Gilead back in 2011, purchasing a late phase HepC pipeline by way of an $11B deal, which, at the time, represented almost 1/3 of Gilead's market cap.

Returning to the apparent mystery of Gilead's relatively low P/E, my thoughts are as follows:
  • The market doesn't just arbitrarily assign a low P/E without reason, especially only two years removed from two blockbuster drugs being introduced to market. The fact that the P/E appears relatively low should be a signal that the market is telling us something about the expectations investors have pertaining to the company going forward
  • The patent protection on both Sovaldi and Harvoni, which accounted for close to 60% of F' 2015 revenue runs through 2029 and 2030 respectively, so there's a 15/16 year runway for incremental cash flows before patent expiry. A low P/E could be symptomatic of market concern over peak cash flows shortly after drug introduction due to pent up demand for initial treatment (or other possible reasons I'll outline below)
  • Peer group large cap biotech/pharmaceutical P/E's measured using Amgen, 17x, Biogen 18x, Abbvie 19x, Roche, 24x, and Novo Nordisk, 22x, average 20x. Applying a similar peer group multiple to Gilead, valuation would either have to rise to $327B from current (i.e., $16B net x 20x), or earnings would have to fall to $5.25B ($5B x 20x = $105B current mkt cap). 
  • The key point here is understanding the case for why earnings may more likely fall vs. a threefold rise in valuation as the overall justification for Gilead's below peer group P/E
Why doesn't the market believe the story?

I found the following articles, courtesy of the Chicago Tribune and Bloomberg, outlining the rationale supporting doubts over future growth.

First up, the Chicago Tribune, link here, summarizing background, current political backlash, and competitive threats to the Sovaldi and Harvoni story.

A few excerpts from the article follow:




In a nutshell (funny I just wrote that because I'm actually eating roasted peanuts as I'm writing this), there has been the equivalent of a political upheaval in response to Gilead's pricing strategy surrounding the introduction of both Sovaldi and later Harvoni. One only need peruse the 2015 10K in order to develop an understanding of how far reaching the consequences might be:


Next up, Bloomberg on competition from Merck, link here, and a few excerpts from this article, which I found fascinating, copyright Bloomberg:





The key takeaway I got from this Bloomberg article is that the case for Sovaldi and Harvoni peak sales seems plausible, even with Zepatier and Viekira each remaining at under $2B in sales through 2020, while Gilead's recently reported year to year variances in Q2 2016 Sovaldi and Harvoni sales seems to suggest the same.

Michael Price on Valuing Pharmaceuticals

How can I attempt to write a piece on attempting to intelligently address the mystery of Gilead's relatively low P/E without referencing Michael Price, who had the following to say about valuing pharmaceutical companies, courtesy of Greg Speicher.com, link here:



So here's my attempt at a Michael Price type valuation on Gilead. Assumptions as follows:

  • 5% decline in Harvoni and Sovaldi revenue between 2016 and patent expiry, no price cuts
  • All drugs facing patent expiry drop to 20% of previous year's revenues in the year after expiry
  • Assume 50% net margins
  • Perpetual cash flows subsequent to 2030 are discounted at 8% 
  • Discount cash flows by year at 12%, compare to current market cap
Results as follows:



Observations: 
  • Cash flows don't take future pipeline &/or drugs under development into account, they only consider current pipeline
  • Cash flows model Harvoni and Sovaldi out to 2030 at linearly declining rates (5% per year). Reality may prove much different, if Gilead bows to pressure and reduces prices with no accompanying increases in patient uptakes. 
  • The market is finite. According to the WHO there are approximately 3-5M US patients with Hepc. At close to 200K treatments sold per year (Harvoni + Sovaldi combined), and no competition from other drugs, courtesy of Merck &/or Abbvie, the US patient population would be close to treated by 3030 (or at least the %ge of the population who can afford the treatment).
  • Is a 50% net margin over time realistic? In years where R&D spend climbs, margins will be lower
  • On the subject of why I used a 12% discount rate, the answer is two-fold, 1) there is uncertainty over what form future sales growth will take impacted by price sustainability, future patient uptake, or competition, & 2) I believe that during R&D heavy years, net margins will be lower, therefore I upped the discount rate
Based on the above, current capitalization at $105M exceeds the sum of my estimated DCF's by around $13B, or just over 14%, and based on Michael Price's comments above, he seemed to only be interested in buying when his DCF's up to patent expiry exceeded current valuation (i.e., he had a margin of safety): in this case, he was buying at a discount and getting the pipeline for free. 

I don't believe this is the case with Gilead currently, and certainly, this is an interesting and counter-intuitive result, because it suggests that Gilead is currently overvalued with a P/E of less than 7x ttm earnings.

Update, Aug 16th, figured I'd add a monthly chart for perspective. The chartist in me asks whether this setup is symptomatic of a base being formed (the answer is no):