WertArt

Selling Rolls-Royce

Posted on June 17, 2018 by WertArt Posted in Sold Leave a comment

On Friday, Rolls-Royce confirmed their prior guidance to reach (and possibly exceed) GBP 1 bn of free cash flow in 2020. The company forecasts GBP 450 m in 2018 (they made GBP 270 m in 2017). On top of that, they announced that it is their “mid-term ambition for free cash flow per share to exceed GBP 1”. This translates into GBP 1.9 bn. Warren East, CEO of Rolls-Royce, has shifted investor attention from profits to cash flow given accounting changes and increasing cash inflows from engine maintenance contracts.

To reach these goals a lot has to be done.

This includes another restructuring program over the next two years targeting GBP 400 m in cost savings while laying of 4,500 employees.

Moreover, quality issues with the company’s in-service engines continue to weigh on Rolls-Royce’s profitability. In Friday’s press release the company states that “At the time of our FY17 results in March we had anticipated that the cash costs associated with in-service issues on both the Trent 1000 and 900 would broadly double from the £170m incurred in 2017. Our current assessment is that the further issues encountered with Trent 1000 since our 7 March announcement could lead to combined additional 2018 cash costs of around £100m. We have, however, successfully enacted a number of short-term discretionary cost mitigation actions separate to, and outside of, the proposed restructuring plan, which we expect to offset these incremental costs. As such our FY18 free cash flow guidance remains unchanged at around £450m + /- £100m.”

From my perspective, this statement implies a hidden earnings revision. Nevertheless, market participants’ attention was focused on long term cash flow targets. The share price reacted favorably to Friday’s news flow.

Given the uncertainty surrounding the “mid-term” target to achieve GBP 1 per share in free cash flow, I want to be rewarded with a return of at least 25% per annum. I assume that Rolls-Royce will be able to reach the one pound per share target in 2022 or two years after reaching the first target of GBN 1 bn+ in free cash.

A 5% free cash flow yield for a company with recurring and growing cash generation seems to be an appropriate valuation. Consequently, Rolls-Royce could be worth GBP 20 per share in 2022. Discounting this valuation back to the present at my required rate of return for this investment, I come to the conclusion that the current price is 17% higher than the company’s intrinsic value.

Therefore, on Friday I sold my investment at 970 pence a share generating a total profit of 23.2% and an IRR of 8.1% over a holding period of almost three years. I might reinvest at a later point in time in case an investment in Rolls-Royce is becoming attractive again.

Disclaimer

The content contained on this site represents only the opinions of its author(s). I may hold a position in securities mentioned on this site. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. As always please do your own research!

Reducing exposure to Italian REIFs

Posted on May 18, 2018 by WertArt Posted in Current 1 Comment

I decided to reduce my exposure to the Italian REIF theme after (i) some fund related info was released to the market and (ii) the political environment in Italy worsened. I made the following transactions

1) Reduced position in Unicredito Immobiliare to 2% of the portfolio at EUR 818 sales price from May 3 to May 17 2018:

Management informed the market that the sales process for the fund’s largest asset in Rome is ongoing. One bidder has been provided with exclusivity. The unit price reacted favorably further closing the discount to NAV. I decided to trim the position as the risk reward relation weakened. The fund distributed another EUR 150 per share at the beginning of Q2 2018.

2) Disposition of Amundi Europa at EUR 1,005 per unit from April 17 to May 17 2018:

As a reminder, the REIFs largest asset located in Rome (26% of gross asset value) is leased to a single tenant (former H3G). After the merger with WIND it is unclear whether the property will still be needed in the future by the current tenant. Former H3G has a break option starting from May 2015 until May 2019.

In addition to that, Europa Immobiliare informed unit holders at the end of March, that “following the occurrence of circumstances not known and not foreseeable at the time of drafting and approval of the final settlement of liquidation” the expected repayment for 28 March was suspended. “The aforementioned suspension is due to extraordinary, unforeseeable circumstances inherent in the liquidation of the direct and indirect holdings of the Fund, currently subject to checks of an administrative, accounting, legal and tax nature“. According to this article, it seems that Italian tax authorities are revisiting the tax structures of Europa Immobiliare 1 former investments abroad (mostly England, Sweden and Netherlands). These properties were held indirectly by the fund through the usage of special purpose vehicles. Now, it is unclear how long the tax review will take (best case three months) and what the effect will be on the outstanding distributions for unitholders of Europa Immobiliare 1.

Coming back to Amundi Europa, it seems that the fund used similar tax structures for European investments ex Italy. Therefore and due to the large single tenant exposure, I decided to realize a total return of 29.4% on this investment. The fund distributed another EUR 236 per share at the end of Q1 2018.

This brings the total weight of Italian REIFs in my portfolio down to 8.4%. The following table provides an overview for each fund (click on the table to enlarge):

Notes to the table:

1) Cumulative write down as a percentage of total historic costs (based on current real estate portfolio).

2) Cash available plus short term investments and current assets less current liabilities as a percentage of current market cap plus debt.

3) From a location perspective; note that other assets in the portfolio might have better characteristics in terms of leasing or asset liquidity.

4) Assumptions: liquidation at current NAV. In the case of Europa Immobiliare this scenario also includes a positive outcome from two legal claims.

5) Assumptions: liquidation of property portfolio at 60% of current appraisal values except for the best asset. Best asset to be sold at current appraisal value.

6) Assumption: liquidation of total property portfolio at 30% of current appraisal value.

7) Equal weighting of each scenario. Except for Unicredito Immobiliare, where the worst case scenario is weighted with 15% given the progress made in selling the largest asset close to NAV.

Disclaimer

Q1 2018 Performance Review

Posted on May 15, 2018 by WertArt Posted in Reporting Leave a comment

WertArt Capital (the “Portfolio”) lost 3.7% during the first quarter 2018. By comparison, a composite – 70% the Euromoney Smaller Europe (Exc. UK) Total Return Index and 30% the Euromoney Smaller World Total Return Index – lost 2.8% during the same period.

An overview of the portfolio’s largest ten positions can be found in the following table:

I am also providing the quarterly portfolio cash streams in the table below:

Disclaimer

Adding to Geospace Technologies

Posted on May 7, 2018 by WertArt Posted in Current Leave a comment

Last Thursday (after market close), Geospace reported quarterly results.

The company reported the first gross profit since the second quarter of 2015, which is mostly a result of lower non cash inventory obsolescence expenses and a declining cost base (the workforce has been reduced by more than 50% since 2014). In addition, they announced a meaningful contract win with a new customer to rent 9,000 OBX nodes (ocean bottom) for a period of 180 days. During the quarter management re-initiated investment activity in the rental fleet with transfers from inventories to rental equipment being more than ten times larger than last year. A continuous increase in demand for rental equipment will be of significant importance to regain profitability due to the high margin contribution from this segment.

GEOS management remains cautiously optimistic in its outlook for the rental fleet. A bolder prediction was made by the CEO of ION Geophysical, a competitor in the Ocean bottom segment:

“We are confident that the OBS market is growing, projected to be at pre-downturn levels of USD 1 bn in 2018, with significant growth projected by the industry in the following years. OBS will continue to take market share from the distressed streamer markets spurred by the improved economics of the next generation of systems as well as growing adoption by E&P companies as a technology of choice to manage their reservoirs.” (Ion Geophysical Q4 2017 conference call)

The non-seismic business continued to perform well. In addition, management reported that they are currently developing products for the border and perimeter security markets. These products are based on the existing seismic sensor technology and might have the potential to further diversify the business in the future.

Cash outflows sum up to USD 10.1 m during the first six months of the current fiscal year. However, operating cash flow (before changes in working capital) improved from a negative USD 6.1 m during the first quarter to a negative USD 0.6 m during the second quarter. The company is holding USD 41 m in net cash.

Lemelson Capital, the third largest shareholder holding 8.4%, intensified his activist campaign (although recently reducing his equity stake). Edit 5/16/2018: Lemelson increased his stake to 9.3% according to the latest 13D/A. He sent two more letters to the company basically demanding the replacement of GEOS management and pressing for the sale of the company. I do not know what is going on behind the scenes, but my impression is that support from other shareholders for these requests is limited. Management has not officially replied yet.

From my perspective, management seems to be very experienced. They are also handling the current downturn with great care. However, I am concerned about the low level of insider ownership:

Looking at the last decade, stock-based compensation has been a large component of management remuneration. For instance, the total intrinsic value of options exercised during fiscal years 2011 to 2013 was USD 35.2 m. This is a substantial part of net profit generated during this period. To be fair however, the share price increased more than 25 times from its low in 2009 until the end of 2013. So, for shareholders with the right timing to sell a lot of wealth has been realized. On the other hand, long term shareholders have been continuously diluted. Since 2009, the share count increased by 1.4 m shares or 12%. This might be similar with many other US listed companies. Nevertheless, management’s ownership in the company moved in the opposite direction. As of December 2009, executive management and the board as a group had an interest in the company of 1.3 m shares (adjusted for a 2:1 stock split) or 10.9%. This has been reduced to 0.5 m shares or 3.9% as of December 2017. At the same time, the board’s and management’s composition has not changed a lot (there is a new CEO, with the current Chairman being the former CEO). Consequently, from the outside it appears that Geospace has (i) a seasoned leadership team that has (ii) already received a relatively large remuneration during the last upswing and (iii) reduced their ownership over the last years.

Currently, I get USD 41 m in cash, working capital of USD 79 m and properties & land at cost of USD 36 m. In addition, there is the operating business itself with USD 13 m fully expended annual R&D spending, a profitable and growing non-seismic segment and the potential for a recovery of the seismic segment. The market is currently valuing the business at USD 150 m.

On Friday, I increased my position to 3.5% of the portfolio at USD 11 per share.

Olympic Entertainment Group – Novalpina Offer

Posted on May 2, 2018 by WertArt Posted in Current 1 Comment

On April 4 2018 Novalpina (a PE investor) launched a cash offer for Olympic Entertainment Group (OEG) at EUR 1.9 per share. The offer expires today on May 2 2018.

The offer values OEG at a trailing 5.4 times EV/EBITDA ratio, a P/E of 9.6 times and a 10%+ free cash flow yield. OEG has no debt outstanding and substantial net cash on its balance sheet. Return on investment averaged 20%+ over the 4 years, I have been holding shares of the company.

Novalpina announced its attention to delist the shares from the Baltic stock exchange after the completion of the offer and after holding an extraordinary general meeting. The termination of OEG’s stock listing is on the agenda of the general meeting scheduled for May 11 2018. As the founders and largest shareholders have agreed to accept the offer, Novalpina will control the majority of the votes at the general meeting (the founding shareholders own 64% of the company). A simple majority will be required at the general meeting for the termination of the stock listing.

After the decision to leave the NASDAQ Baltic OMX stock exchange, OEG will make a written request to the Exchange Listing and Surveillance Commission to terminate the securities listing on the stock exchange. According to this source, there have been instances when the delisting was denied. However, it seems likely that the commission will approve the OEG case given that OEG shareholders will have already received a take out offer from Novalpina.

Novalpina’s following moves are outlined in the offer document:

“The Bidder intends to have the OEG Shares delisted from Nasdaq Tallinn to be resolved in an Extraordinary General Meeting of OEG, following completion of the Offer. In such case, shareholders not accepting the Offer will no longer have liquid OEG Shares. The Bidder further intends the merger of OEG as transferring entity into the Bidder as assuming entity. The shareholders not accepting the Offer will be offered new shares in the Bidder. These shares will not be listed on Nasdaq Tallinn nor on any other stock exchange. Finally, provided the Bidder holds at least 90% of the OEG Shares, the Bidder intends to decide to take over the remaining OEG Shares in accordance with § 1821 of SMA. If the 90% threshold is not met after completion of the Offer, the Bidder intends to first implement the merger and, if following the merger the Bidder holds at least 90% of the OEG Shares, intends to pursue the takeover of the remaining OEG Shares.“

“Provided the Bidder holds at least 90% of the OEG Shares following the completion of the Offer, the Bidder intends to decide to take over the remaining OEG Shares for a price not lower than the Purchase Price in accordance with § 1821 of the SMA, and respectively, hold an Extraordinary General Meeting of OEG for that purpose. Such resolution of the Extraordinary General Meeting may be made within 3 months after the expiry of the Acceptance Period. The resolution of the Extraordinary General Meeting of OEG regarding the takeover of the remaining OEG Shares is adopted if at least 9/10 of the votes represented by the shares are in favour. If such resolution will be adopted following the lapse of the 3-month period after the expiry of the Acceptance Period, 95/100 of the votes represented by shares shall be in favour of such resolution.”

As to the sequence of the Merger on the one hand and the takeover of the remaining OEG Shares on the other hand, the Bidder intends to first implement the takeover of the remaining OEG Shares and only subsequently merge OEG into the Bidder, if the Bidder holds at least 90% of the OEG Shares following the completion of the Offer. If the 90% threshold is not met after completion of the Offer, the Bidder intends to first implement the merger and, if following the merger the Bidder holds at least 90% of the OEG Shares, intends to pursue the takeover of the remaining OEG Shares.”

Consequently, not accepting the offer will result in a higher offer price, if Novalpina is able to squeeze out minority shareholders (either at 90% or 95% ownership) and decides to take out the remaining shareholders for a price higher than the original purchase price.

At the same time, Novalpina might increase the offer price in the following scenario:

If they get close to the 90% threshold, they might be willing to extend and increase the offer or to purchase shares at a higher price to get above 90%. In this scenario and according to the prospectus, the increase will also benefit shareholders, who previously accepted the offer:

“In case the Bidder or any of the Novalpina Group Companies acquire OEG Shares after the Offer has been made public and before the results of the Offer have been made public at a price higher than the Purchase Price, such higher price shall be retroactively extended to the Offer but not to OEG Shares acquired by the Bidder from the market outside the framework of the Offer. In this case the terms of the Offer must be changed pursuant to § 7 of the Rules and the change must be published immediately on Nasdaq Tallinn web page.”

Before I make a decision, it makes sense to look what other shareholders (might) have done. The majority owners holding 64% of the company have already announced that they will accept the offer. In addition, I estimate that Novalpina until today acquired another 14% of the company in the open market (given the trading history and Novalpina’s announcement as of April 10 2018). Consequently, they need another 12% of shareholders accepting the offer to reach the 90% squeeze-out hurdle. (As of YE 2017, 12% of shares were held by mutual funds/institutional investors who might not be allowed to hold unlisted securities).

This is a difficult decision. On the one hand I think that the current offer price undervalues the company.

On the other hand, the prospect of owning shares that cannot be traded and the relatively low probability of an increased squeeze out offer after (potentially) waiting for months looks even less attractive.

Therefore, I decided to accept the offer price. At a sales price of EUR 1.9 per share I realize a total return of 20.0% and an IRR of 6.2% over a 4 year holding period.

Disclaimer

Spectrum Brands Holdings (NYSE:SPB)

Posted on April 26, 2018 by WertArt Posted in Current Leave a comment

I am establishing a 3.5% portfolio position at today’s VWAP in Spectrum Brands Holdings with a limit price of USD 75 per share.

Edit 4/27/2018: VWAP USD 68.82 per share

Disclaimer

Adding to Sarine Technologies

Posted on April 12, 2018 by WertArt Posted in Current 6 Comments

Sarine Technologies provides machinery and software to the midstream diamond processing industry. The midstream sector is placed between the producers of rough stones (upstream) and the retailers of polished diamonds (downstream). There are about 5,000 manufacturers most of them located in India (1).

Sarine has played a major role in transforming the industry with the help of their automated solutions for every stage in the manufacturing process from the rough stone to the polished diamond. Sarine is mostly selling to the larger manufacturers providing them with a cost advantage over the smaller players in a very low margin business.

Sarine has a 70%+ market share and a monopoly position in some product segments. Their leading position in this relatively small market results in high returns on capital with profits reinvested in product development to strengthen the company’s competitive position.

But that’s not all: their growing installed base of machinery delivers recurring revenue streams that currently account for roughly half of revenue. In addition, Sarine recently started to market products for the downstream retail sector (2) and diamond grading. So far, contribution to total revenue from products targeting new sectors has been small. Management is targeting a 5% revenue contribution from these new products in 2018.

Currently, a number of risks and uncertainties weigh on the stock price:

Since its peak in September 2014 when the company was valued at SGD 1 bn, the share price has lost about 60%. This is partially due to two years (2015 and 2017) where industry headwinds weighted heavily on operating results. In the latest annual report, the company’s Chairman Mr. Glinert provides a good summary of the headwinds Sarine has been facing.

1) There has been substantial oversupply of polished diamonds due to the following reason:

“The normal production cycle of the diamond industry is driven by the fact that half of the annual retail sales worldwide are concentrated from November — China’s Singles’ Day, India’s Diwali and Black Friday in the U.S., through February — Chinese New Year and Valentine’s Day. Polishing is catalysed by the sell-off of inventories throughout the industry value-chain during this four-month period. As downstream wholesalers and retailers replenish their inventories, midstream manufacturers adjust their output accordingly and typically slow polishing activities when the downstream demand cools. However, as the industry is fragmented, and little, if any, information is shared, and as the cycle time from buying rough diamonds to finishing polished diamonds is at least three months, the midstream usually overshoots with production. There is a consistent cycle wherein in Q3 there evolves an oversupply of polished diamonds in the midstream. The degree of overstocking varies from year to year and is dependent on many factors – actual consumer demand, how aggressive the producers are at offering rough diamonds, how aggressive the manufacturers are at competing for said rough, at what point the manufacturers realise the demand for polished has slowed, relative prices of rough and polished stones, etc. This year, primarily due to the aggressive sale of rough by producers still working down their excessive inventories from 2015 (they sold more carats in 2017 than they mined), and correspondingly aggressive buying by the manufacturers, the build-up of inventory was significantly higher than the norm. This is evidenced by the very significant drop in rough stone sales by the producers in the second half of the year (e.g., the DeBeers sights from July onwards), after the manufacturers realised their situation. Consequently, the corresponding slowing of manufacturing activities in the second half of the year is the primary reason for our weaker results in the second half of the year.”

In summary, the midstream sector’s margins are squeezed by their suppliers (rough stone producers) and their customers (retailers and wholesalers). From time to time, supply of polished stones exceeds demand by a wide margin. This leads to an even weaker position of the midstream sector and therefore lower demand for Sarine’s products and services.

However, in February 2018, management reported that diamond sights have come down in 2018 and that retail sales were better than last year. In the annual report released at the beginning of April management confirmed this positive trend pointing out that they are expecting a relatively strong year for the industry (3).

Moreover, besides the up and downs of the midstream sector there seems to be a structural shift going on in the diamond cutting and manufacturing industry. A number of banks have reduced their borrowing activity to the midstream sector. And recently one of the biggest bank scams in Indian history was uncovered directly related the Nirav Modi who owns diamond manufacturing and retailing. Ultimately, I expect midstream segment consolidation to speed up as small manufacturers have to leave the market due to tight margins and more stringent regulation. A more transparent midstream sector consisting of fewer but larger players should benefit Sarine’s business activity in the future.

2) The other headwind results from Sarine’s technological leadership as intellectual property infringement saw a sharp increase in 2017. This is mostly the case in India, by far Sarine’s most important market. As Mr. Glinert explains in the annual report, management is taking all judicial measures to protect their intellectual property and is trying to increase awareness of these infringements with retailers and wholesalers of polished diamonds.

Moreover, they are also relying on technology to protect their property:

“The newest Advisor® 7.0, protected by proprietary home-grown cloud-based cyber protection, has many enhanced features. Comparative testing between Advisor® 7.0 and the older version hacked by the illicit competition shows the polished stones planned using the newer software have a significant tangible added value in actual dollar terms. Advisor® 7.0 also has functionality specifically aimed at enabling the manufacturer to better meet today’s retail trends for branding — optimising modified cuts, light performance enhancement, etc. These valuable add-ons, along with other commercial incentives noted below, motivate manufacturers to migrate upwards to the latest version…”

According to the company, out of twenty thousand systems sold, eleven thousand have so far transferred to the protected Advisor® 7.0 Software.

In addition, infringements can now be uncovered by various software control tools that have been implemented in Sarine software systems to prevent misuse.

Going forward, I expect that it will become more difficult to copy Sarine’s product and that the impact of patent infringements has reached its peak in 2017/2018. Encouragingly, management believes that Sarine managed to retain its market share in the midstream manufacturing segment of the diamond industry in 2017. Although the number of stones processed declined and product piracy took business away, Sarine was able to set a new record of 10 million scanned stones (4).

3) There are a number of additional risks that could affect Sarine’s operations including:

First, the technological advancement of man made diamonds has progressed over the last years. Consequently, there is a risk that synthetic diamonds substitute demand for natural diamonds at some point in the future (5).

Apart from that, the current geopolitical situation will affect the diamond industry, if US/EU lawmakers impose sanctions on Russian diamonds. With Russian state run Alrosa controlling 30% of annual diamond output any export restrictions would have a severe impact on market supply.

A brief look at management/shareholders and valuation:

The company’s directors have significant insider ownership holding about 12% of the company. David Block was appointed CEO in May 2017 after joining the company in 2001. Most managers have been working at the company for at least a decade. Mr. Block is currently holding 0.8 m shares and he will shortly be granted 1.2 m options at market price vesting over four years.

In December 2017, Mondrian Investment Partners and Shareholder Value Management exchanged their position, with Shareholder Value now being the largest outside shareholder holding 9.2% of the company.

Like many of my other investments, the company has a pristine balance sheet with USD 29 m of net cash. The current enterprise value is USD 277 m. I think that the company should be able to achieve normalized net profit of USD 20 m going forward valuing the company at a 13.8 times cash adjusted multiple.

Given the company’s

high earnings quality,
strong ROICs,
leading product development capacity in its industry,
recent product launches targeting new markets,
high recurring revenue stream,
a history of returning excess cash to shareholders,
and a low financial leverage,

I think shares of Sarine should trade at a significantly higher multiple.

After building an entry 2.5% portfolio position in September 2017, I have been increasing the position to 3.5% after the release of the annual report at an average price of SGD1.14 per share.

Disclaimer

(1) India is the largest diamond cutting and manufacturing centre with total rough diamond imports pegged at $17 billion per annum. Hence, India, especially Surat, processes around 90 per cent of diamonds mined around the world.

(2) A number of Asian retail chains including Soo Kee Group in Singapore, Shining House in China, Golden Dew in South Korea, K-Uno in Japan and Aurora in Thailand have already adopted Sarine’s retail solutions in 2016 and 2017.

(3) See also: http://www.paulzimnisky.com/global-diamond-supply-expected-to-decrease-3-4-to-147m-carats-in-2018

(4) Since its release into the market in 2009, the inclusion mapping technology / Galaxy® family of systems has provided inclusion mapping data for rough diamonds in major diamond processing centres wordwide. The company states that the system has “revolutionised planning and production processes by maximising polished diamond yield, while expediting the manufacturing cycle and reducing human error.” Over 30 million stones cumulatively have been scanned since the technology’s launch.

(5) See also: http://www.paulzimnisky.com/the-price-of-lab-created-diamonds-relative-to-natural-continues-to-fall

Selling Retail Holdings

Posted on March 28, 2018 by WertArt Posted in Sold 4 Comments

Back in November 2013, I invested in Retail Holdings (ReHo). At that time, the company was already in the process of selling its assets and returning net proceeds to shareholders with the ultimate goal of full liquidation.

At that time, I derived at the following valuation:

”ReHo has currently approx. 5.3 m shares outstanding. I came up with a market value for ReHo’s share in Singer Asia of USD 133.2 m or USD 25.16 per share. In addition, a value of USD 19.3 m for the SPV Notes translates into USD 3.64 per share. Last but not least the company has USD 6.5 m in cash or USD 1.23 per share. This leads to a NAV of USD 30.03 per share. At a current price of USD 19.25 the share is offering a 56% discount to NAV.”

While it turned out that the SPV notes were worthless, management was able to maximize Singer Asia’s asset value and sell many assets with almost perfect timing (e.g. sale of Singer Thailand). In addition, management repurchased 12% of shares outstanding at attractive prices. The good sales process was also a consequence of executives/insiders directly profiting from a smooth liquidation in the form of equity ownership and incentive fees.

After 4.5 years, I have so far received USD 19 per share in dividends. The stock is currently trading at USD 13 per share or a 30% discount to reported NAV.

During the first quarter 2018, I sold my position at 13 USD per share realizing a total return of 98.6% and an IRR of 21.2%. Total contribution to portfolio performance since inception was 2.9%.

The rationale for this transaction is that around 70% of the assets are in the form of shares held in Singer Bangladesh. Therefore, the remaining portfolio has become much more concentrated than it was the case in 2013. More than a third of the Singer Bangladesh shares are restricted as “to the remittance of dividends and the proceeds from the sale of these shares.” Management is seeking an elimination of this restriction, but currently a sale would only be possible at a material discount I assume. Apart from that, last year’s momentum of continuous sales activity has stopped for quite some time now. Therefore, I think that the investment has become more risky and that the current discount to NAV reflects a fair assessment by market participants.

Disclaimer

Pason Systems (TSE:PSI)

Posted on March 5, 2018 by WertArt Posted in Current Leave a comment

After my recent investment in Geospace Technologies, I am buying another service provider to the upstream sector of the oil and gas industry. Pason’s equipment is installed in over 1,000 onshore drilling rigs or 65% of all rigs in the Western hemisphere. Mid cycle operating margins reached 25% over the last cycle with ROCE in the 15%+range. Operations have been very volatile during periods of squeezing demand (like in 2009, 2014 to 2016), but Pason has been a steady compounder taking the last two decades of the company’s history into account.

I think that the company is well equipped to profit from an industry recovery due to (i) a strong competitive position, (ii) new product introductions and geographic expansion opportunities, (iii) high operating leverage and (iv) relatively low investment requirements going forward. On top of that, I get a pristine balance sheet and high historic earnings quality.

The key to Pason’s operational success is the application of technology to recording what is occurring at the well head. 20 years ago, this was an area where bigger companies were not paying attention to. Pason under the leadership of Jim Hill used this lack of attention to develop products that quickly covered the market before the competition could react.

Pason’s Electronic Driller Recorder (EDR) is the company’s primary product and generates 45% of total revenues. The EDR links the rig manager, rig crew, operator, geologist, mud logger, directional hand, and drilling operations technician, on a common data network. By providing secure communications via broadband satellite or wireless networks, the EDR system enables rigs to share drilling data, reports, and real-time well information with office-based personnel. The system can also provide Internet access for wellsite users. Additionally and very importantly, the EDR provides the platform for other Pason products like the Pit Volume Totalizer (15% of revenue), AutoDriller (6%), Gas Analyzer (7%).

In terms of new product development, the company has recently invested in data management solutions to help the customers to increase drilling data streams to the back office and provide analytical tools for these data streams. In addition, the company is improving its offerings with regard to so called drilling intelligence to further enhance drilling optimization and automation at the rig site (for instance Pason received the license for Exxon’s Drilling Advisory System). Lately, Management reported that these products are gaining traction based on first trials with customers. If these new product launches turn out to be successful, this will be a direct consequence of keeping investment activity in R&D stable during the current downturn. Pason is investing a healthy 10% to 15% of revenue in research occupying 25% of the workforce. New products will also have the potential to increase revenue per installed EDR.

Over the last three years, the company has been shifting its investment activity from the hardware side to software development and solutions. They spent CAD 192 m in 2013 and 2014 combined to invest in new hardware for rental equipment. Capex spending came down significantly from 2015 to 2017. Management expects annual capex to stay around CAD 25 m to CAD 30 m over the coming years (one fourth of 2014 spending) as the focus on software product development will require less capital expenditures going forward. This has already a positive effect on cash flows and will also provide support for income generation over the coming years as D&A continuously decreases.

During the latest downturn beginning in late 2014, management has reduced operating run rate costs by CAD 100 m (20% of 2014 peak revenue), helping the company to stay free cash flow postive.

Management summarized the effect of cost reduction in the Q2 2017 conference call:

“The impact of previously implemented cost reduction programs is highlighted by comparing this quarter’s results with the second quarter of 2015. While revenue was essentially at the same level, EBITDA increased from $7.5 million the second quarter of 2015 to $21.1 million in the second quarter of 2017. Our recorded net income was also much improved. We expect to continue to reap the benefits of our lower fixed cost structure into the foreseeable future.”

In addition and according to management, PSI was able to defend market share in all key markets with limited price concessions.

Speaking of market share, PSI serves close to 90% of its home market in Canada and 50%+ of the US market. They also have a leading position in LATAM and Australia and are currently gaining traction in the Middle East. According to management, the company is now operating in a stable duopoly with a third player operating an inhouse system in the US. At the moment, there is strong investment activity in the US (mostly Permian basin), while Canada is behind due to the reasons discussed in this article.

Over the long term, Pason has shown terrific growth rates being one of the best performing E&P servicers listed on the stock market. At the same time, operating volatility has been high following the E&P industry cycle. For instance, in 2014 revenues reached an all time high of CAD 500 m and declined to only CAD 160 m in 2016. In 2017, revenues recovered to CAD 245 m. While management reduced the cost base over the last three years, there continues to be a large degree of operating leverage in this business. According to management, in 2017 incremental EBITDA margins were 79%. Management believes that incremental margins might be even higher by a couple of hundreds basis points going forward.

Pason has a CAD 1.5 bn market cap, no debt outstanding and CAD 154 m in cash. Management has been focused on increasing the dividend over the years and mentioned that given current company’s excess cash on hand a further increase in the dividend is likely. Historically, the company’s acquisition paved the way to enter new markets. Recently they made a small purchase by acquiring visual analysis software company Verdazo. Managements remuneration is skewed to a relatively high equity component with more than 5 m stock options or 6% of total shares outstanding. Options vest over three to five years. Current average exercise prices are roughly 15% above the current share price. Management has generous change of control clauses in their contracts and will be rewarded in case of Pason being acquired. James Hill, who led the company for 25 years is now Chairman and still holds 10%+ of the company. He has been selling shares but this might be related to financing his interest in philanthropy and horse racing.

Valuation

In 2017, the company generated EBITDA of CAD 85 m. Accordingly, the company is valued at a 16 times trailing enterprise value to EBITDA multiple.

I think this is an attractive price for the following reasons.

I think it is likely that we are at the beginning of an industry recovery with demand increasing over the coming years. According to management, recent forecasts expect E&P spend to grow 5% internationally and 15% to 20% in US in 2018. If this expansion scenario comes true, there will be substantial top line growth potential and therefore margin enhancement due to operating leverage. Assuming that revenues will revert to a normalized level of 60% of peak levels (achieved in 2014) this results in a revenue potential of CAD 300 m. Based on 80% incremental margins, EBITDA can reach roughly CAD 130 m. This turns then into 10 times multiple.

In addition,

Pason’s earnings quality has been excellent. Cash conversion from EBITDA is usually very high. Return on invested capital and operating margins over the business cycle have been strong.
New product releases should help to foster the company’s competitive position and provide additional revenue upside.
Pason can grow internationally. For instance, they started to install on Saudi Aramco’s rigs in Q2 2017. As of Q3 2017, they already had a market share of 15% in Saudi Arabia with 30 of a total of 200 drilling rigs using Pason’s solutions. They are also starting activities in Oman, the United Arab Emirates, Qatar and Kuwait.

After the release of Q4 2017 numbers, I bought a 3% portfolio position at CAD 18.2 per share.

Disclaimer

Sell Francotyp Postalia

Posted on February 19, 2018 by WertArt Posted in Current 3 Comments

With the physical letter volume shrinking, the demand for franking machines is abating. Francotyp Postalia (FP) however is a good example for a company that can prosper in a declining industry. Only two other companies are offering franking machines including Pitney Bowes and Neopost. In addition, the distribution of franking machines is highly regulated. This provides for attractive industry characteristics. FP invested early in the technological enhancement of low volume franking machines. This is (so far) a stable segment and FP is the technological leader grabbing market share from the two other incumbents. While the competition focuses on the development of new services, FP is broadening the geographic footprint entering new markets and investing in new leasing equipment. With the replacement cycle of old franking machines in the US mostly completed, I was invested to participate in strong free cash flow generation from a highly predictable recurring revenue stream over the coming years.

In 2016, the management changed. The new CEO released a road map leading all the way to 2023. Ambitious goals were announced. So far however, there has been a high amount of “non-recurring” costs. Investment in efficiency and new product development have been made. For me it is difficult to quantify future cost efficiencies and to predict whether investments in new products will turn out to be successful.

Moreover, the company’s other business lines are weak. The mail services segment barely breaks even and suffers from intense competition and deteriorating economics. The software segment generates healthy margins but revenues are stagnating and they recently lost their largest client. More resources might be needed to restructure or reposition this part of the company.

From a valuation perspective a 3.5 times EBITDA multiple looks attractive. In my investment case, I assumed that required investments will go down leading to lower D&A and therefore higher EBIT over the years. Therefore, we would also see higher free cash flows and cash return to shareholders. Unfortunately, this has not been the case so far. Cost overruns and continued investment will cap EBIT at EUR 10 m in 2017. Consequently, the company is valued at ten times operating profit (For comparison, shares of competing Neopost can be bought at eight times EBIT). With EUR 4.5 m of free cash flow in 2017, FP trades at a 6% yield. As I do not see much improvement in 2018 as well, this turns out to be a high valuation for this type of company. FP is operating in a declining industry (although they are increasing their market share) and has to carry around the mail services business that might never be generating noteworthy profits in the future but requires substantial resources. I think it is time to move on and to sell the shares.

I started selling shares on February 15, 2018 with a limit of EUR 4.3 per share. At this sales price, this investment generated a 11.9% total return and a 3.8% IRR over a 3.5 year holding period.

Disclaimer