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.

2 comments:

  1. NCC sounds really interesting.

    I double-checked and it sounds like the class A shares have coattail provisions. Old restricted voting share classes (pre-1987) often do not have, say like Becker Milk. From the AIF:

    "The Class A shares carry one vote per share and the Class B Common Shares carry ten votes per share. In the event of a vote to change any right, privilege, restriction or condition attached to either the Class A shares or Class B Common Shares, the Class B Common Shares are entitled to one vote per share. In addition, the ten votes attaching to each Class B Common Share shall be decreased to one vote 180 days following the acquisition of Class B Common Shares pursuant to a take-over bid where the ownership of Class B Common Shares, after the acquisition, exceeds 50%. In all other respects, these shares rank equally."

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    1. Thanks for the comment JP, great observation

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