SRL: What Is Dead May Never Die (PT: $26, ~150% upside)

Note: all dollar amounts converted to USD unless otherwise noted

Current price: $10.35

Basic shares: 12.5M

Options: 0.5K

Market cap: $130M

Market cap (fully diluted): $131M

Net Cash: $49M

Adjusted run rate EV/EBIT: ~7x

Executive Summary

Scully Royalty Corporation is primarily a semi-hidden iron mine royalty company that’s trading at ~7x run rate EBIT (based on mine operator-reported August production data and current iron ore prices) or ~2x EBIT on guided 2021 production numbers. The primary asset is “semi-hidden” as the underlying mine only restarted operations in June of this year. Moreover, SRL has not officially announced current production levels as they only report results on an annual basis despite an NYSE listing (minimum requirement of Cayman companies). I believe the opportunity exists primarily because this company is a complicated hodge-podge of disparate deep value assets and most investors aren’t yet aware of the restart of the mine. I believe SRL has upside potential of $26 (150%) on a 10x EV/EBIT multiple driven by royalty payment increases and downside risk to net cash at $3.75 (-65%).

Snap calculation results in undervalued company on current production numbers, could be a home run on guided numbers:

The key asset here is the royalty on Scully, an iron ore mine in West Labrador in Canada. The terms are 7% net on revenues from iron ore produced through 2055.

SRL has ~$3.75 in net cash (net of a loan payable). At a current stock price of $10.35, subtracting the excess cash on the balance sheet gets us to a price of around $6.60. Assuming August 2019 run rate iron ore production (1.8M tons annualized), we get a EBIT/share of $0.65 (1.8M tons * $80/ton spot iron ore price * 7% net royalty * (1 – 20% royalty tax rate)/13M shares), so on the royalty asset alone SRL is currently trading at nearly a 10% pre-tax yield. The mine operator has guided to 6M tons per year production in 2021, which would result in an EBIT of ~$2/share or an obscene ~30% pretax yield.

You could argue that there should also be some administrative expenses incorporated. Labrador Iron Ore Royalty Corporation, which receives a royalty on an iron ore mine that is basically right next door to Scully, shows 2018 royalty revenues of $105M and $3M in G&A expenses (http://s1.q4cdn.com/337868174/files/2018-Annual-Report-Final.pdf). Or you could just assume SRL’s 2018 operating loss of ~$11M (~$0.10/share) is all attributed to the royalty asset. Regardless the current numbers are great, and the potential 2021 figures make this a potential home run.

Not to mention, there’s still some other assets on the balance sheet to account for that we’ll get to a bit later.

Recent developments at Scully are on schedule, on budget, and impressive:

Tacora is the mine operator that bought the assets in 2017. They have been providing regular updates on their progress, and the most recent one is really impressive: https://www.tacoraresources.com/wp-content/uploads/2019/09/Scully-Mine-update-18-Sept-2019.pdf

The key points:

1. Ramp in production (slide 11):
   1. June: ~23K tons
   1. July: ~82K tons
   1. August: ~153K tons <- 1.8M annualized run rate
2. Schedule and 2021 guide (slide 15):
   1. 6MTPA (million tons per annum) guide for 2021
   1. Almost everything is on schedule if you compare with their November 2018 deck.
3. High grade ore with good characteristics (slide 6)
   1. 65.9% iron, better than industry benchmark of 62%

A bit about the underlying mine economics. Cliffs shut down the mine in 2014 due to high costs. Tacora secured funding from Cargill and a few funds to purchase the asset in 2017 (Cargill also agreed to buy 100% of the produced iron through 2033). They claim to have a cash cost of ~$41/ton (slide 7 here).

Keep in mind the royalties are a percentage of revenues, so cost matters most if prices hypothetically decline to level where Tacora decides to quit producing. As a point of reference, iron ore prices troughed at $63 during the Great Recession and $39 in late 2015, the latter of which is slightly lower than the claimed “cash” cost per ton, so it seems that the mine would produce in all but the worst cases and in at a worst case $40 scenario, your valuation multiples would simply double (since royalty revenues drop straight to marginal operating income) and remain undemanding.

Macro:

Little idea. Really. But the hellish last 5 years in commodity-land combined with unfortunate Vale issues has me thinking that pricing will more likely go up than down.

Other assets add a bit more value:

Scully Royalty Corporation used to be known as MFC Bancorp (and MFC Industrial previously…and Terra Nova Royalty Corporation before that…). The point is that this was a holding company with a bunch of assets as a consequence of its misadventures ranging from foreign miners (MFC Industrial) to merchant banks (MFC Bancorp). As a consequence of all this, there’s still a bunch of far-flung zombie assets on the balance sheet. By my calculations I’m arriving at another ~$1.50 in value:

Subtracting this $1.50 in addition to the net cash results in a 7x run-rate EBIT multiple and 2x on 2021 guided numbers. Saying this again, this is potentially a 40-50% pretax yield.

Management and Insider Ownership:

Michael Smith is the Chairman and CEO and has been with the company since 1996 with a brief hiatus as major shareholder Peter Kellogg won an activist tilt against the company. Executive compensation seems reasonable to me, with Michael Smith taking in $630K last year and the CFO taking in $300K.

Executive share ownership is a bit of a worry, with Michael Smith only owning 0.9% of the company (~$1M). However, there’s a bunch of well-known microcap investors involved. Peter Kellogg owns 33%, Lloyd Miller’s estate owns 15%, and Nantahala owns 7%. And to reiterate Mr. Kellogg has shown that he is willing to get his hands dirty, going activist and electing himself onto the board in 2014 (before stepping down again in 2015).

Valuation and risks

I view downside as pretty limited since there’s $3.75 of net cash on the balance sheet, so in a bear case I don’t think the stock would go down materially below this level (~65% down). On the other hand, applying a 10x EBIT multiple on the royalty asset and adding in cash and other net assets, we get an upside valuation of $26, an 150% increase from today.

As a point of comparison, Labrador Iron Ore Corporation ($LIF.TO) which was mentioned briefly before, trades at a ~$1B CAD enterprise value ($1.45B market cap with ~$80M in net cash and $380M in equity in its underlying iron ore mine) and did ~$100M CAD in EBIT last year (when iron ore prices were higher than today in 11 of 12 months) for a 10x EV/EBIT multiple.

There’s a litany of other risks, led by commodity price fluctuations. The complexity of the organization also introduces risks (anybody have any clue about Maltese banking laws, Ugandan environmental obligations, or Chinese eye care regulations?). There’s also a strange loan payable at a subsidiary that SRL is fair valuing at $4M despite an undiscounted obligation of $42M. SRL says that this is a non-recourse loan that a former subsidiary owes, so it would seem that the true liability should be even less than $4M.

Disclosure: Long

Chronicle of a Cheap Canadian Consolidation Play: CRH Medical (CRH/CRHM)

Price Target: $5.80 (~70% upside)

Note: all numbers are in $USD.

Summary

CRH Medical (“CRHM”) is an extraordinarily cheap $250M market cap consolidation story in the gastroenterology anesthesia services business. It’s just about the perfect setup. It trades at ~10x EV/EBITDA and has historically made bolt-on acquisitions at 4-6x EBITDA, typically using cash and sometimes topped off with earn-outs and/or deferred obligations. Capital expenditures are basically non-existent ($125K in 2017), and thus EV/(EBITDA-CapEx) is also at ~10x. Plus, there’s almost certainly further upside in cost and operational synergies, and these multiples don’t even back out the typical “non-recurring” acquisition costs which would make the valuation even more attractive. 3Q:18 EBITDA attributable to shareholders was up 10% y/y, despite a 10% y/y headwind from reduced reimbursements from changes in CMS 2018 Medicare Physician reimbursement codes. Perhaps the only glaring negative for this company is that insider ownership of shares is just 4% (with about another 3% in options and share units), but the company has repurchased shares in the past year and, with the renewal of its repurchase program on November 5, will likely do so over the next year as well .

I think this business should be worth 15x EBITDA-CapEx at the very least, and likely closer to 20-25x due to the consolidation opportunities. Moreover, there are two imminent catalysts:

1. CRHM will convert to U.S. GAAP and file a 10-K for 2018. This would increase the ownership base to many indices/mutual funds that cannot own non-GAAP filing companies. Right now, index ownership isnon-existent.
2. The aforementioned 10% y/y EBITDA headwind due to changes in CMS 2018 reimbursement codes goes away beginning 1Q:19.

At 15x EBITDA-CapEx multiple, the target price is $5.80, or 70% upside from current levels. The company is dual listed on the TSX (ticker: CRH) and NYSE (CRHM).

Legacy Business

CRH Medical’s legacy business sells disposable ligators for hemorrhoid treatment (their “CRH O’Regan System”). It accounts for just ~10% of the business today and is declining high single digit percentages y/y, and really the story doesn’t depend heavily on this. The primary U.S. and Canadian patents for this system expired in March 2016, which drove management to evaluate strategic alternatives and led to the move into the anesthesiology business. All you need to know is that hemorrhoids are a gastroenterology issue and thus a history of selling product gives CRH Medical access to and credibility with gastroenterology physicians that they can leverage in their consolidation efforts in the gastroenterology anesthesia services business.

New Direction

The gastroenterology anesthesia services business is a full turnkey model which CRH Medical launched with a $73 million acquisition of its first gastroenterology anesthesiology practice (by far its largest acquisition) in December 2014. CRHM becomes the exclusive provider of anesthesia services at gastroenterology practices (operating outside of hospitals). CRHM handles everything from recruiting, staffing, and accrediting anesthesiologists to collecting and billing patients. The main motivation for practices to sell is to outsource the paperwork and regulatory complexities to a third party, and is the medical practice equivalent to companies outsourcing non-core functions (real estate, payroll, etc.) to focus on their core business.

Notably, CRHM only acquires the exclusive professional services agreement and the ultimate ownership of the practice remains with the physicians (CRHM only goes after practices where the physicians have an ownership interest in). Hence, this is a very capital-light acquisition, not to mention a much easier integration process than most consolidation stories. Again,these have historically been acquired with an average valuation of under $15 million at multiples around 4-6x EBITDA. There is also a long runway for growth with an estimated 800-1,000 total practices in the U.S.

This is a Quality Business

CRH Medical provides Propofol anesthesiology which puts patients to sleep for the duration of an endoscopy procedure, which a quick review of literature suggests has faster recovery times relative to other sedation methods and fewer side effects. Like many anesthesiology practices there does exist controversy (Consumer Reports advises patients to use the lightest tolerable sedation methodology),but I’d note that this is an accepted practice by Medicare which surely has done its vetting. There has been a trend towards increased use of Propofol for endoscopies in recent years, and my belief is that medical practices are generally slow to change but changes tend to stick.

Anesthesiology EBITDA margins are between 40-50% and capital expenditures are virtually non-existent. This business is also virtually recession-proof.

Management

CEO Edward Wright has a luxury brands background at Cartier,while CFO Richard Bear previously worked at ID Biomedical which was acquired September 2005 for $1.4B. Management generally seems pretty good, and the recent transition into anesthesia was an excellent move. Since CEO Edward Wright joined CRHM in September 2006, CRHM’s stock increased at an 8% CAGR which comfortably outpaced the S&P 500 (+6% CAGR) although not exceptional.However, since they transitioned into anesthesia in December 2014, performance has been excellent if volatile at a 24% CAGR (vs. the S&P 500 at 9%).

The only unfortunate aspect, again, is that management and directors owns a mere 4% of outstanding shares (~$10 million), while their total comp is quite high ($4 million each for the CEO and the CFO in 2016).However, I’d note that a lot of this is incentive comp (base is $350K and$325K, respectively) and the 3-year average compensation is about $2 million for both the CEO and CFO. Ideally I’d like to see insider ownership in the 10%-30%range but this is really the only quibble I have with this idea. Execution of a successful consolidation story is very hard work and good performance should be rewarded with good compensation.

Again, this is counteracted by share repurchases. The prior repurchase conducted over the past year cancelled 2.2 million shares at an average of $2.39.

Risks

However, there are obviously risks. The near-term risk is changes in reimbursement fee schedules, which is precisely what happened this year. However, historically, reimbursement fees are changed only once-in-a-while, and with the change as of January 2018, it should be at least a few years before the next one. Moreover, CRHM managed to grow EBITDA materially despite the headwind, an indication of the strength of the business.

A mid- to long-term risk is medical innovation, namely fecal and blood tests. This is more troublesome to me and as a generalist is much more difficult to ballpark. Management thinks that the impact of such tests are not necessarily negative: in their view these tests will bring a significant portion of the population who are not currently complying with colonoscopies into compliance, and these tests would result in increased need for colonoscopies to follow up on fecal and blood tests.

Valuation and Summary

Most consolidation stories trade at materially higher EBITDA multiples (even on a post-synergy basis) and also have much greater execution risks as they typically take over entire businesses instead of just a small part of continued operations. I think a 15x EBITDA-CapEx multiple is very fair ($5.80 or 70% upside). However I wouldn’t be surprised if this trades at 20-25x (135%-200% upside), and the lower end is roughly where CRHM traded at all-time highs in March 2017.

Initial credit for this idea goes to PSDFinancier via the excellent Microcap Club.

Disclosure: long

Don’t Oversubscribe to the Benefits of Subscription Businesses

This insight ought to be somewhat controversial: the celebrated subscription aspect of SaaS businesses is overrated. A SaaS business is dominant not because of the recurring aspect of its business model but rather because of its competitive position primarily and ideally buttressed by excellent products and customer service. While this may not seem that revolutionary, there are a lot of investment theses out there that generally follow this script: 1) high near- and intermediate-term growth and 2) eventual high margins. As David Einhorn pointed out in his 3Q letter (the catalyst for this insight), “It turns out that businesses that matured into very high margin businesses generally demonstrated strong margins at relatively low revenue levels.”

What’s the reason high margins don’t materialize? That’d be competition. If the business plays in a commoditized market with low barriers to entry and low switching costs (think: most food delivery apps), it cannot afford to lower sales costs and/or raise prices. There’s always someone willing to do it for cheaper. The biggest curse: eye-popping growth numbers, sky-high total addressable market size, and impressive theoretical “steady state” profit margins all conspire to increase competition and reduce actual “steady state” profit margins.

So that’s why you need a dominant competitive position. There are few viable alternatives to winner-take-most businesses such as Microsoft Office or Adobe Acrobat, which is why their eventual SaaS dominance is virtually assured despite near-term transition pains. Google Search is the same way, although it’s not a conventional “subscription” business (but is a SaaS business). A dominant competitive position gives you pricing power to maintain those precious margins.

If  your competitive position is not nearly as dominant, excellent products and customer service is the next best thing. Without excellent products and customer service, you’re extremely dependent on switching and/or search costs to keep customers.

So the fundamental question shouldn’t be “does this business have recurring revenues?”, but rather, “does this business have a competitive advantage?”. The subscription model is superior to the transactional model because of 1) better insights into customers and 2) more predictable revenue streams, but the business model is a secondary consideration to the business’ quality.

Moreover, while subscription businesses are growing rapidly today, it is unlikely that growth rates can persist at double digit rates in perpetuity. Eventually, greenfield opportunities will dry up because there are limitations to how much and how fast the pie can grow. When that day comes, subscription businesses will increasingly look at introducing services in adjacent domains in an effort to maintain growth. A subscription business lacking a dominant position and still fighting with other competitors will likely struggle to compete against new competitors who have successfully achieved dominance in adjacent domains.

Subscriptions are good because of the recurring revenue and payment upfront (resulting in negative working capital), but ultimately what matters is the competitive position, products, and customer service. In other words, it’s still not all that different this time.

Disclosure: Long MSFT

(Executive) Search for Value: Caldwell Partners (CWL.TO / CWLPF)

NOTE: units are Canadian dollars unless otherwise stated

Price target: $2.20 (~60% upside)

Summary:

This idea was initially generated from the excellent investor letter put out by Ewing Morris: https://www.ewingmorris.com/wp-content/uploads/2018/07/June-2018-Final.pdf

Caldwell Partners (“CWL”, ticker is CWL.TO or CWLPF) is a cheap, tiny, and high-quality (but cyclical) executive search business. It trades at ~5x EV/EBITDA with minimal CapEx needs (roughly similar EV/(EBITDA-CapEx)), with $8M of excess cash on the balance sheet. Management and employees own 30-40% of the company and the original founder who started the firm in 1970 owns an additional 14% but is no longer involved in day-to-day operations. I think fair value today is around $2.20 a share, or ~60% upside from today’s levels, and with the right capital allocation decisions (aided by the addition of activist investor Darcy Morris to the board) over time this could become a multibagger. The valuation caught my eye, but the long-term vision of the company (notably announcing plans to expand into the US. In February 2009) and the above-average quality are what excited me enough to buy shares.

Company Description:

Caldwell Partner’s business is executive search, specializing in board and C-level hires. They compete against the traditional “Big 5” of Korn Ferry, Heidrick & Struggles, Egon Zehnder, Spencer Stuart, and Russell Reynolds. While CWL has significantly fewer resources to compete with the big boys, they do have one advantage: they have a broader base of potential candidates to recruit from because their bigger competitors will rarely poach executives that they’ve recently placed.

In terms of economics, CWL is generally paid a retainer of 1/3 of the estimated first year cash compensation for the people they recruit, and is trued up (or down) when the actual compensation is determined.

CWL operates with 39 “partners”, which are employees with significant autonomy in how they recruit and generally already have significant experience in doing so. CWL has contracts in place where the partner takes a base salary and roughly 50% of the revenue they bring in (in excess of their base).

This business is obviously cyclical, as fewer companies are looking for executives and current executives are less apt to move during tough times combined with the fact that compensation likely declines as well. However, the revenue share agreement does offset some of the cyclicality and management’s goal is to avoid losing years.

Industry growth has been decent: according to IBISWorld executive search annual growth from 2013-2018 has been at 3.4%, so GDP+ but not by much.

Company History:

CWL was founded as a Canadian executive search company in 1970, went public in 1989, and is today a $28M market cap company with 39 partners (including one added after the past reported quarter) and $65M in LTM revenue. CWL said it has made money in every year prior to 2007, and in my review of the past 20 years they had positive operating income on an adjusted basis in every year except four, 2001, 2008, 2009, and 2010 (2013 operating loss was due to severance costs). I think that part of the reason for the continued losses in 2009-2010 is that, in February 2009 in the teeth of the Great Recession, management announced a plan to expand into the United States. It’s admirable that Caldwell had the long-term vision that enabled them to add talent and grow when most businesses were contracting.

More recent events:

1. January 2014: CWL did a secondary placement. This was the only dilution going back to at least FY 2007 and wasn’t necessary in terms of capital. Management explained that it was done virtually exclusively with partners and management, and was intended to align the interests of the partners and management with the company. The raise increased share count by 4.0M and raised $3.3M in cash.
2. October 2014: CWL acquired London-based Hawksmoor Search. Adds presence in the UK. There has been some turnover in partners, as they added 2 additional partners, let go of both as they were not performing as expected, and then added 3 more in the last year (including one on 9/20/18).
3. July 2015: CWL entered into a 5-year licensing agreement with a Latin America search group. Terms that call for receiving a 2.25% royalty payment per year for the first 3 years (originally first 2, renegotiated 1 year extension), and a step up to 4.25% thereafter. Note that this would kick in in July 13, 2018, and as their fiscal year ends August 30, we would see roughly half of this benefit this upcoming quarter.
4. July 2015: CWL rejected a unsolicited takeover offer from U.S.-based executive search firm DHR International. The explanation was that the partners were not interested in becoming a part of DHR as the compensation philosophy was different. While disappointing that they incurred $164K in legal expenses and bought back DHR’s 5% stake at a price of $1.40/share (generally higher than it traded until recent months), I think it’s actually the right move in the broad scheme of things: a partner revolt likely would destroy CWL’s value, although declining the deal certainly hurt near-term shareholder returns.
5. November 2015: CWL entered a licensing agreement with Simon Monks and Partners Limited in New Zealand. Simon Monks and Partners subsequently changed its name to The Caldwell Partners International New Zealand Limited, which demonstrates that there is brand value even internationally.

Today 70% of revenues are generated in the U.S., 25% in Canada, and 5% in Europe. Given that this is a Toronto-based, TSX and OTC listed stock that’s more aptly described as a U.S. company, I think there’s a potential for mispricing.

Valuation:

Here’s how I’m getting to my valuation:

For reference, $596M market cap Heidrick & Struggles trades at ~10x EV/(EBITDA-normalized CapEx) and $2.8B market cap Korn Ferry trades at roughly 12x EV/(adjusted EBITDA-CapEx) (adjusting for impairment taken in most recent quarter). Notably, both companies have single digit percentage insider ownership so CWL actually has a more aligned incentive structure. I originally used a 10x multiple for CWL but decided to take it down a turn to 9.0x due to liquidity and domicile.

Operating Margin Sanity Check:

TTM operating margins are at 5.2%, which is roughly the same as FY17 margins (5.3%) but materially higher than previous years (2.1% in 2016 and 3.9% in 2015). It’s hard to get a real sense of what normal operating margins are, given that there’s been significant changes in the operating model (added U.S. in 2009, U.K. in 2015) and environment (tech bubble in late 90s when operating margins were over 25%). I think a reasonable “steady state” operating margin assumption is to look at CWL’s Canadian operating margin average of 4.1% for the 16 years 2001-2008 (so that it excludes the tech bubble years) and 2010-2017 (so that it excludes the 2009 expansion into the U.S. which detracted from Canadian results as Canadian segment operating margins worsened materially to -25% in 2009 from -9% in 2008). On this basis, CWL is over earning currently, and on a “normalized” EBIT margin EV/EBIT would be 6.9x vs. 5.4x currently, which is still cheap.

Capital Allocation and Strategy:

Uncharacteristically, many of the ideas I have looked at recently pay dividends, as I generally prefer buybacks due to tax efficiency. This one’s paying a healthy 5%+/year, or $0.02/quarter. That said, with CapEx needs of $400K-$500K/yr judging by the last couple years relative to the $400K in dividends and $4.1M of TTM EBITDA, there’s plenty of room for both a dividend and disciplined growth. Moreover, Ewing Morris’ Darcy Morris has joined the board in an advisory capacity and explicitly says in his letter that there is “much to work with”. I believe that over the long run this could be a multi-bagger as 1) the market recognizes the current undervaluation and 2) the low-capital intensity underlying business compounds in value.

Risks:

-Possibly overearning: Operating margin appears to be above historical averages.

-Cyclical: Although the business has a high variable cost component to it, executive search remains a very cyclical business: hiring slows and compensation packages get slammed in a recession.

-Competition: The Big 5 have far more resources at their disposal, which is partially offset by conflicts of interest at the Big 5 due to size.

-Execution risk: They operate in 3 countries, of which Europe’s results have historically been very lumpy.

Disclosure:

Long.

As usual, this is not investment advice and please do your own due diligence.

10/3/18 Edit: Added valuation table that was initially omitted, numbers are edited to reflect closing prices as of 10/3/18.

 

Introductions

Hello world! This blog is intended to be another investing blog, providing a public, verifiable record of my successes and failures. My investment style is to pursue investments that are offered at a discount to what I estimate them to be worth because the investment are either 1) forgotten, 2) ignored, or 3) hated, with a strong preference for the first 2. I generally will not invest in businesses I do not comfortably understand. Asset classes, geographic segments, growth rates, quality, capacity to invest, etc. are all secondary considerations to the ultimate arbiter: price.

Here’s a working example that applies this philosophy. I believe that the overall trend towards index funds and ETFs will generate certain distortions in the financial markets. While a broad index fund generally preserves the relative market capitalizations of the underlying investments (one reason it does not perfectly do so is that indexes are float-adjusted), individual sector specific ETFs likely do generate momentum for “hot” sectors that can end poorly (recent example: Biotech). As such, some areas will inevitably get “hot”, and others will be ignored. What’s ignored? Here’s a few working ideas:

1. Orphan Companies: Some publicly traded companies do not fit nicely into an industry classification, so sector funds would ignore those stocks.
2. Microcaps: Too small to attract significant index interest. Lower fund fees also make it even harder for large, active institutional investors to make looking at tiny companies worth their time. Canadian microcaps have the added bonus of being unfairly hated due to the commodity drawdown a couple years ago.
3. Holding Company Discounts: Maybe the reason holding company discounts exist is because to my knowledge most ETFs or indexes do not care about discounts and/or cannot arbitrage securities.

My search process can and will migrate over time as sectors, strategies, and asset classes move in and out of favor, but once again, the overarching point is to avoid the crowd, particularly in cyclical investments which are more likely to suffer manias and panics.

I should probably close with some disclosures. I’m not a financial adviser, anything on this blog is not investment advice and/or a recommendation to buy or sell securities, and for the love of <insert important item to reader> please do your own due diligence.

I look forward to discussing ideas with you.