Investment memos

Genterra Capital Inc (GIC CN) – From an Irrational Price to an Irrational Price

God the market is weird. For over 4 years Genterra traded at a totally irrational price (see my original investment memo). Immediately after the company announced a share buyback and spin off worth CAD$ 2.25 (CAD$ 1.96 in cash and $0.29 of value in a new security) there were two trades at $1.91 and $1.97 allowing you to create Genterra Energy for free (see my update article). Now the security trades at $2.45 valuing Genterra Energy (“GEI”) at an equity return as low as c. 2.6% for a yield stock with no growth prospects.

In addition to the valuation of GEI I was also going to comment on independent valuation included in the management information circular as I think it is flawed in a number of places but have decided against it as my time is probably better spent searching for the next Genterra as opposed to railing against being short changed vs fair value.

To be clear I am selling my Genterra stock tomorrow as soon as there is a bid in the market.

Genterra Energy

You can find the management information circular here which provides all the detailed background on the transaction and GEI.

Appendix E deals with the valuation of GEI and provides you with the following key inputs:

  • The annual energy output is 812,495KWh
  • The Feed In Tariff (FiT) has a 20year life expiring in 2014 and is set at CAD$ 0.635 per KWh
  • To reflect the decline rate in the solar panels over time you should reduce the energy output but 0.7% per year
  • GEI has a $60k per year management agreement with Highroad (related party owned by the Letwin family)
  • There is a loan of $2,557,970 which bears a 4% interest rate and amortises in equal instalments of $511,594 in years 2030 to 3034

There is no mention of rent payable by GEI to Genterra but in previous reports of Genterra they have mentioned that $50k per year of rent was payable by GEI for use of the roof of their properties. It is also worth noting that Highroad was previously happy to manage the solar park for $30k per year as per the last Genterra reporting.

I built a rough and ready model for GEI the output of which you can find here: Genterra Energy Valuation (2015.08.02).

My model shows equity free cash flow without ongoing rental payments from GEI to Genterra and also net as it is not clear from the circular. It is worth noting that operating and administrative expenses for GEI for the first 6 months equated to c. $67k which might point to rent being paid going forward. It also does not ascribe any value to the solar equipment at the end of its 20 year life. From the little I know there is value to the “repowering” of solar parks at the end of their life but given GEI doesn’t own the land on which its solar assets are on I don’t think you can assume that any benefits would accrue to GEI in this case.

The market is currently valuing GEI at CAD$ 0.49 vs my view of fair value at CAD$ 0.21 which is derived from wanting a 15% equity return over the life of the FiT whilst assuming no repowering and also that Genterra charges you rent.

Put another way the current price indicates that investors are willing to earn a 2.57 – 4.55% equity return over the 18 years depending on the answer to the rental question. On top of this the security will be very illiquid as the free float will remain at 28% of total shares. In addition you will still have the risk of related party transactions as you did owning Genterra, namely that Genterra related entities are providing: all management services for GEI, are the landlord for the site your park is on, and; are your lender.

It feels great to take advantage of Mr Market’s irrationality both on the way in and the on the way out as my track record is much closer to both buying and selling too early.

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Other articles

A Swing & A Miss! (No. 1)

“I call investing the greatest business in the world because you never have to swing. You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! and nobody calls a strike on you. There’s no penalty expect opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it. The problem when you are a money manager is that your fans keep yelling, ‘Swing, you bum!'” Warren Buffett

It is really difficult to find good investment ideas and when you do it is even harder to have the conviction and fortitude to size them appropriately. I read a lot of annual and quarterly reports in a given week and a vanishingly small number show characteristics that warrant further work. Of those that do a depressingly small amount withstand further analytical scrutiny and make it into my portfolio.

This post is intended to be a regular feature of securities that initially peaked my interest but fell down after further analysis. I hope people will find it interesting and hopefully spot things that I have missed in my review that may make them hidden gems.

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ACE Aviation (ACE/H CN)

Insufficient upside / downside profile

ACE Aviation is the liquidation of the historic Air Canada holding company. I absolutely love liquidations due to locked box nature of the balance sheet and the aversion they seem to cause in most investors. Alongside determining the asset side you often have to assess a set of associated liabilities, the costs of realising the assets and finally the weighted average life to realise the assets.

Taking a quick read of the ACE reporting the estate is now effectively a cash box with a market cap trading at a c. 12.4% discount to ultimate realisation (when I was looking it was at CAD$ 0.50 vs 0.52 today). Obviously this is not a prospective investment that would set the world on fire but given the difficulty finding good value candidates I was thinking it could have a place in my portfolio as a substitute for cash.

The reason for ACE being a miss is rather embarrassing and relates to me miss reading the units in the discussion section of the reporting believing that the only remaining contingent liabilities, the tax indemnities, were being quoted in CAD$ when in fact they were in CAD$ 000s.

Post dividend I estimate the expected realisation and associated returns for shareholders from the ACG estate as follows:

ACE Aviation Valuation (2015.08.02)

What this analysis doesn’t capture is a remaining contingent liability that relates to a tax indemnity ACE provided to Air Canada in 2010 totalling CAD$ 50.1m. The reporting states that “the large majority of the input tax credit claims covered by the indemnity in favour of Air Canada expired at the 2014, with the remaining reassessment periods gradually expiring by 2016.” Given this the timing of the estate’s first dividend since entering voluntary liquidation (April 2015) makes sense in conjunction with the dismissal of other contingent claims. The liquidator also states that “Future distributions of ACE’s remaining net cash to its shareholders are subject to the expiration or settlement of any contingencies.”

I cannot find in any disclosure exactly how much of the CAD$ 50.1m indemnity expired in 2014 but my guess that something close to the cash retained remains outstanding. This investment is a miss for me due to the lack of downside protection. Whilst no tax claims have been made for c. 4/5 years if any did arise between now and 2016 you could get wiped out and a c. 10% return is no enough to take that risk.

South African Property Opportunities Plc (SAPO LN)

Lack of return for illiquidity and currency risk

SAPO is a listed property fund that is in the process of liquidating. The fund invested in development land in South African focused on Industrial, Retail and residential purposes. The equity is listed in the UK but all the assets are denominated in ZAR. The board changed asset manager in the middle of 2014 to try and manage the costs of the wind down.

See below for my valuation:

SAPO LN Valuation (2015.08.02)

What I really liked about this potential investment is the fact that cash, unconditional sales, and properties under offer net of the non-controlling interest, loans from third parties and the 1.5% performance fee on the expected sale price equates to c. 80% of your purchase price which provides a good level of downside protection.

The problem with the investment is that the upside after taking account of expected cost to realise the assets is not very compelling at 1.42x. Given that jurisdiction and the fact that it is undeveloped and in certain cases non- permitted land I would want 1.75 – 2.00x expected return. Also whilst not having any macro views the ZAR/GBP exchange rate is extremely volatile and has been going the wrong way. It never feels good to be buying a company in a currency different from the currency of its underlying assets and is clearly much harder to hedge.

Finally all of this is pretty academic as it is one of the most illiquid stocks I have ever seen trading only once or twice a month which further points to the need for a meaningful return. I would be a buyer at c. GBp 14.00

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Investment memos

Emerson Radio (MSN US) – The Hour Between the Dog and Wolf

The Hour Between the Dog and Wolf is originally a French saying (Entre chien et loup) which is multi-layered. It is used to describe a specific time of day, just before night, when the light is so dim you can’t distinguish a dog from a wolf, however, it also expresses that limit between the familiar, the comfortable versus the unknown and the dangerous (or between the domestic and the wild). It is an uncertain threshold between hope and fear.

This is very much the feeling I have when I contemplate the latest developments at Emerson radio (see: original memo)

As a quick summary refresher the Emerson Radio long thesis can be boiled down into the following salient points:

  • Ugly company, in an ugly situation and with very ugly corporate governance issues
  • Company has two US businesses: (i) low grade white goods distribution (micro waves & fridges), and; (ii) license / royalty business for the Emerson TV brand in the US
  • The white goods business is roughly cash flow breakeven whilst the royalty business generates between $7.5 and 8.7m of cash flow a year which on the market cap net of cash is a monster free cash flow yield
  • The controlling shareholder, Grande Holdings, has been in bankruptcy in Hong Kong since June 2011 and its owner has a history of bad acts both at Emerson and elsewhere. It has been working on an emergence from bankruptcy but has been rolling delays since June 2014
  • The company has contingent liabilities totalling $20.1m in the form of three pieces of unpaid US tax claimed by the IRS which the company is disputing. At least one of the IRS’ claims which is a liability of $4.8m seems to be a strong case for the IRS in my opinion
  • At the time of investment I had a low / high recovery of  $1.96 – $3.19 per share assuming no value for the US white goods business
  • I initiated a 5.0% my position on the 27th April 2015 at $1.35 per share

Since then it has been a bit of a rollercoaster as described below

Delayed Filing of Annual Report (WOLF!)

On the 29th June 2015 the company filed a NT 10-K which stated that:

“Emerson Radio Corp. (the “Company”) is unable to file its annual report on Form 10-K for the year ended March 31, 2015 (the “2015 Form 10-K”), within the time period prescribed for such report without unreasonable effort or expense. The delay in filing is principally attributable to the Company’s need to analyse certain transactions and additional information relating to income taxes and potential income tax liability resulting from the U.S. Internal Revenue Service assessments and the Company’s appeal thereof in order to complete the disclosure in the Registrant’s financial statements and the 2015 Form 10-K. Please refer to the Company’s periodic reports filed with the Securities and Exchange Commission for additional detail regarding such tax assessments. The Registrant anticipates that it will file its 2015 Form 10-K no later than the fifteenth calendar day following the prescribed filing date.”

The stock duly tumbled from a trading range of $1.30 – $1.40 to $1.12 and ultimately a low of $1.07 per share. As discussed in my original investment memo I was not able to get any colour or edge on the tax claims save that they were historic in nature and the company was confident that they would be defeated. Given the track record of the company and the fact that they had not changed their auditors from the bad old days their statements gave me no confidence. Ultimately I was not in a position to add to my holdings post the drop due to a lack of conviction around the tax outcome which is never a good place to be. However, I was confident that even if everything went against Emerson the intrinsic value was still 40% above where I acquired the security.

The Published Annual Report (DOG!)

Emerson published their annual report on the 14th July 2015 and it was a beat to worst case expectations.

As a reminder the tax issues were (i) two disputes related to income tax issues concerning overseas income (NOPA 1 & 2) totalling $15.3m of maximum liability, and; (ii) one dispute regarding withholding tax on dividends totalling $4.8m. On the NOPA 1 & 2 claims Emerson has reached a settlement with the IRS where it estimates that it is subject to additional federal and state income tax of $3.0m. The IRS has also agreed to not impose any penalties, a substantial beat to the $15.3m worst case (pre penalties).

What is really unclear to me based on the reporting is whether the $3.0m has already been paid by the company, eaten up by their NOLs, or is still a cash outflow to come. In the 10K Note 5 they make reference to the total $3.0m being recorded as income tax expense in Q4 2013-2015 (Q4 2015 being March 2015, i.e. their 10K). Further on in the note it suggests that they have provisioned the full $3.0m of tax for 2015 but also show a tax benefit of c. $1.5m for 2014. Finally on the balance sheet I cannot find either the $3.0m provision or the net provision of $1.5m. The only item that definitely captures the tax liability is $847k of Income Tax Payable. There are also new liabilities of $500k due to affiliates and $481k long term liabilities. It is a totally mystery to me so if anyone has cracked it or got an answer from the company it would be grate to connect.

Turning to the operating results the big negative announcement was that company expects that its customers (basically Target & Walmart) will cancel further product offerings during fiscal 2016 which will account for c. 15.0% of gross revenue. This comes off the back of Walmart cancelling two microwave oven products commencing in Spring 2013 which knocked off c. 30% of Emerson’s revenue (2014 revenue declined by 42% vs 2013) and pushed them from $5.2m of EBITDA in the US business to $(655)k of EBITDA. Stripping out exceptional legal and tax advisory related to the IRS dispute the US retail business was roughly flat in terms of EBITDA. The business has a positive working capital position so the decline in revenues will release some cash.

Licensing revenue was basically flat YoY, however, 2013 licensing revenue was inflated by unreported licensing revenues from one of the Emerson’s licensees of $1.2m being recognised in the period meaning that the actual like for like increase in revenue was 15.2% which will have partially been driven by the new licensing agreement with Funai which lasts until 2018.

See below for an updated net creation value on a high and low case as well as an summary of the historical results of the business which should provide some colour (apologies I have not included the balance sheet and cash flow as they are v. vanilla).

Emerson Radio Creation Value (2015.07.25)

Emerson Radio Summary Financial Results (2015.07.25)

Given the developments and a trading price of $1.15 per share the business is now trading below cash despite a healthy cash flow generation from the royalty stream net of the losses on the US retail business. My biggest worry around the business is the fixed cost nature of the Emerson’s US white goods business. Conceptually I would have thought that what is effectively a pure play distributor and brand owner would be able to adjust their cost base to declines in revenue in order to maintain a similar margin but the 2014 EBITDA decline suggests otherwise. The only reason I could think for this not being the case is either: (i) a reduction in product units ordered means that the manufacturers have increased their unit prices cutting into margins, or (ii) insufficient cost cutting by Emerson management. We will have to watch the quarterly results closely to see how they deal with a further 15% reduction in revenues.

Grande Restructuring Update (DOG OR WOLF?????)

As a reminder Grande is the ultimate holding company of the entity that owns c. 56% of the Emerson shares. It went into liquidation in June 2011 and originally the liquidators had envisaged selling Emerson as part of the process, however, in May 2014 they reached an agreement with Grande’s main creditor Sino Bright (later revealed as an entity controlled by Mr Ho the controlling shareholder of Grande before it filed for liquidation) which envisaged a restructuring and resumption of trading on the Hong Kong exchange. Since May 2014 there has been an almost comical string of announcements declaring the delay in the publication of the restructuring circular and resumption proposal due to further scrutiny from the stock exchange regulator and promising a resolution 2/3 months after the date of the update.

It seems there has finally been a breakthrough on the 1st June 2015 when Grande announced that “the Stock Exchange has decided to allow the Company to proceed with the Updated Resumption Proposal subject to satisfying its conditions by the 21 December 2015.” The conditions are effectively the release of the shareholder circular and implementation of all the restructuring steps. This is clearly the next catalyst in the Emerson story with the Circular due on or before the 31 August 2015 (it must have happened at least 5 times).

Unfortunately only time will tell whether Grande and Mr Ho take the form of a dog or wolf. In my mind shareholder bad acts remain the biggest risk to this investment with the performance of the US white goods business coming in a distant second. I think there is a good chance that a dividend of a significant portion of Emerson’s cash balance may be part of the Grande restructuring proposal in order to ensure the company is well capitalised and also to fund the takeout of non-consenting creditors which hopefully will lead to a re-rating in the stock as the market is forced to consider the cash flow generation of the combined Emerson business vs the market cap.

A combination of the revised upside/downside metrics and my evolving thoughts on portfolio concentration I am adding an additional 2.5% to upsize my Emerson position to 7.5% of my portfolio.

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As an aside the Hour Between the Dog and Wolf is also an excellent book by John Coates who was a successful wall street derivatives trader turned Cambridge neuroscientist which examines the body’s chemical influence on risk in men. In short there is a feedback loop between testosterone and success that dramatically lowers the fear of risk in men and similarly a loop between intense failure and a rise in levels of cortisol the anti-testosterone hormone that lowers the appetite for risk across an entire spectrum of decisions.

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Investment memos

Caltagirone Editore – Q1 2015 Results, Onwards & Upwards

I originally posted about Caltagirone Editore on the 15th March 2015 where I initiated a 2.5% position at EUR 1.000 (see: original post). As is the way since adding the position the stock has got drilled falling to a low of EUR 0.820 and currently residing at EUR 0.858 a healthy 14.2% loss since initiation. However, the Q1 2015 results released on the 7th July 2015 tell a different and more positive story.

As a brief reminder Caltagirone Editore owns 6 newspaper titles, 1 TV station, an ad agency and a web portal in Italy. It is part of the wider Caltagirone SpA which is a complex web of companies that form the family holdings of Francesco Gaetano Caltagirone an Italian billionaire ranked number 258 on the Forbes list (as an aside I have a position in the holding company which I will update on separately).

At investment my basic thesis on Caltagirone Editore was:

  • Market cap was trading at a 50.6% discount to (i) cash on balance sheet, (ii) equity stakes in Unicredit & Generali, and (iii) liabilities without ascribing any value to the operating business
  • Caltagirone Editore is the second largest Italian newspaper group with c. 22.5% share of average daily readers and also has the 4th most visited news website in Italy. Pulling all the titles together the group has a 61.4% share of average daily readers in Central Italy vs Gruppo Espresso at 28.3%
  • From a macro perspective Italy has the lowest internet penetration in the European Union and the highest number of Small & Medium enterprises meaning that Caltagirone should have the time and opportunity to ride the internet wave as opposed to having been already left behind by google and other first movers
  • Finally, and most importantly, whilst Caltagirone is EBITDA negative the cash burn of the group is very small vs its liquid net assets and has been improving due to (a) reducing rate of revenue declines, and; (b) impressive cost cutting by management

So what has changed since investment?

2014 FY Results & Q1 2015 Results

The first thing that is illustrative is to look at the creation value of Caltagirone Editore at the time I invested vs today

Caltagirone Editore Creation Price (2015.07.25)

Not a huge amount has changed with cash increases (some of which will be season working capital) offsetting the decline in value of their stakes in Unicredit & Generali.

What is much more interesting and informative is the performance of the business in Q4 2014/FY 2014 & Q1 2015

Caltagirone Editore LforL Results Evolution (2015.07.25)

Positive takeaways

  • Ad revenues have shown a continued reduction in decline rate which I hoped for as Europe and in particular as Italy recovers from the crisis and is helped by Dragi’s QE binge
  • They continue to successfully cut costs to address the declining top line
  • The business was P&L EBITDA positive for FY 2014 for the first time since LTM H1 2011! This trend has continued into 2015
  • Cash burn is decreasing driven YoY and if they maintain the latest run rate you are only burning 1.3% of your c. 60% margin of safety a year

Negative takeaways

  • The pace of circulation revenue decline is increasing which is worrying. The business in the past has been able to offset readership decline which began in 2008 and as of 2013 ran at 12.2% decline YoY with price increases. If they have reached the limit the customer will bear we could see double digit decline rates on this line item
  • Cash taxes are high. I think this is because each paper is owned in a separate entity and whilst the combined group is PBT negative some of the titles are tax payers. This is really annoying as without tax they are in touching distance of cash flow breakeven

Unfortunately IR has not yet posted the 2015 annual general meeting presentation which in the past has contained useful data on the market including Caltagirone’s average daily readers which allows you to look at revenues and costs on a per reader basis which I think is a more insightful way to analyse the evolving performance of the business. As an aside I have spread annual performance back to 2007 and quarterly performance to Q1 2012 and am happy to share with people but haven’t posted as it is in a messy format. Also the business only produces a cash flow at the half and full year so we unfortunately cannot look at cash burn on a quarterly basis.

Caltagirone Editore is not for the faint hearted. Whilst there is a massive pile of cash and liquid securities vs where you are creating the company if they stop being able to cut costs or push through price increases to offset the declining readership (the pace of which has not stemmed yet) then the cash burn could absolutely balloon. Newspapers are also trophy and political assets to the owners and the Caltagirone family may value having the influence these titles bring over protecting the value in the group by shutting down struggling titles.

Ultimately I think that creating a business that has real market leadership in the 8th largest economy in the world for free and being protected by monetisable asset worth 2x your creation price is too cheap an opportunity not to have in my portfolio. Having said this I have only sized the position at 2.5% which speaks volumes although I do have a 2.5% position in Caltagirone SpA which at the time I thought was effectively a 5.0% position in the Caltagirone complex as they were effectively correlated (not sure this is really true).

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Track Record

HIPS Performance Track Record (Q2 2015)

HIPS Performance Tracker (2015.07.24)

Apologies to anyone following the blog I have been getting crushed at work so there has been less activity on the blog than I would have like during Q2 2015. That said I do have some interesting things in the hopper and hope to be posting more frequently going forward.

Whilst the value portfolio was down significantly in Q2 2015 there were no specific catalysts behind this other than Mr Market’s mood as only Genterra Capital had news and it was positive. Whilst on the subject of moves in securities for no reason I passed on the Unitech Corporate Parks liquidation (see: original article) in late Feb 2015. At the time I looked at the security it was trading at £0.0295 and was pricing a 2.48x pay-out to loss ratio. I passed as I felt a 3.00x ratio (£0.0252 buy price) was appropriate risk / return ratio given the jurisdiction. Since the post the stock has gained 18.9% on absolutely no news. I felt it would be a good discipline to track the performance of the securities I passed on as well as those that make it into the HIPS portfolio as frustrating as that will inevitably prove to be.

An eagle eyed follower spotted that my return calculations for the passive portfolio in Q1 2015 were incorrect. I hope to have corrected this in the latest iteration which adds dividends onto the total current value instead of netting them from my in price which is counter intuitive. Please let me know if there any bugs feedback is always helpful

Q3 2015 is already shaping up to be a more interesting quarter in terms of action on some of the securities in the value portfolio so stay tuned!

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Genterra Capital

  • Released H2 2015 (March) results. Very much steady as she goes
  • Continued investment in the solar generation business which is showing good revenues
  • Real estate plods along nicely

Caltagirone Group / Editore

  • No reporting or events

Emerson Radio

  • No reporting or events

 

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Investment memos

Genterra Capital Inc (GIC CN) – A 1.65x MoM and a 154% IRR and I Still Feel Cheated

19th July 2015

Genterra Capital Inc was the first security I bought as part of my blogging experience and will be the first monetisation event as well. Hindsight is obviously a wonderful thing and as a result I have split this post into two parts addressing: (i) what has happened at Genterra and the expected outcome, and; (ii) lessons learnt from the investment

For reference my 4th January 2015 Genterra investment memo can be found here

1. What has happened at Genterra

On the 10th July 2015 Genterra issued a press release stating that:

  • The Letwin group will acquire 100% of Genterra Capital Inc post the spinoff of 28% of Genterra Energy
  • Consideration to be paid for Genterra Capital Inc will be CAD$ 1.96 per share plus 2 Genterra Energy shares for each Genterra Capital share owned
  • Any shareholder that owns less than 500 shares in Genterra Capital Inc will receive CAD$ 2.25 in cash for each share

As a reminder the Letwin family own c. 70% of the outstanding shares through seven different vehicles. There is little detail on Genterra Energy other than it will own the solar power assets that have been developed by Genterra Capital Inc. The implied value of Genterra Energy is CAD$ 0.29 (difference between small & large shareholder cash out offer) on 16,628,716 shares for a total of CAD$ 4.8m.

As with Beaumont Select Corp (blog post here) I cannot help but feel that the minority shareholders are getting screwed here. In my original underwrite of Genterra I made three conservative assumptions:

  1. 20% holding company discount to my fair value calculation
  2. Using the book value of the property as opposed to the current market value
  3. Not reflecting any value for the solar power projections being developed by Genterra

With these assumptions I assessed the fair value of Genterra to be CAD$ 2.90 per share which would mean the takeout offer of CAD $2.25 is at a c. 20% discount to a conservative fair value. However, this understates the discount the Letwin family are achieving as (i) on a takeout offer the holding company discount should disappear as it is now a control transaction, and; (ii) the board should be looking for an acquirer to pay the market value of the properties. At book value the properties were yielding an 8.5% unlevered return after deducting costs which were over 50% of the rental income which seems abnormally high and suggests that management should  be able to monetise these properties for a substantial premium to book value to a buyer with a more efficient cost structure.

Removing the holding company discount and including the book value of the solar generation equipment (which is delivering a c. 11.5% unlevered return based on the first years extrapolated revenue) I get to a value per Genterra share of CAD$ 3.80 implying that the Letwin family are acquiring the minority shareholders stakes at a substantial 40% discount to fair value without factoring in the market value of the properties.

The beauty of the Letwin offer is that they can deal with the minority shareholders out of cash on balance sheet (CAD$ 5.5m assuming CAD$ 2.25 takeout price) and still have CAD$ 10.0m of cash left to pay themselves an extraordinary dividend.

It is unclear to my why they are choosing to spin off Genterra Energy or what the exact details of the company are but I am sure all will be revealed in due course.

In terms of an outcome for the HIPS portfolio this catalyst will crystallise a return of at least 65% based on the day 1 valuation of CAD$ 2.25 which will result in a P&L of GBP£ 327 (using constant currency) and an IRR of c. 154%

2. Lessons Learnt

a.The Need for a Catalyst

Re-reading my original investment memo the biggest issue I had with the investment was the fact that it was an illiquid security coupled with the existence of related party transactions. I specifically noted in my first memo that “We are adding Genterra as a 5% position to the HIPS portfolio. If the stock was more liquid and the level of related party transactions lower it would be a larger position”. The other thing that I was acutely aware of was that there was no obvious catalyst to close down the value gap.

In the 6months since starting this blog I am now of the view that a security trading at a material discount to fair value is a catalyst in and of itself. I also think that the more illiquid a security the more likely it is for real pricing inefficiencies to occur and therefore see a lack of catalyst and illiquidity as often linked.

The case of Beaumont Select and now Genterra demonstrate that a material discount to fair value compels the control shareholders to act in order to arbitrage the value disparity. Even in the absence of a controlling shareholder an independent management team would be compelled to buyback stock faced with the kind of discounts to fair value that Genterra was trading at vs deploying capital in other investment opportunities available to them.

b. Be Prepared to Take Advantage of the Market

Since the Dec 2011 results published on 22 March 2011 576,993 shares representing 24% of the total minority shareholding and 7% of the outstanding share capital traded at a weighted average price of CAD$ 1.51. I charted the multiple of money return (“MoM”) to the takeout valuation that you would have made if on every Genterra share sale that occurred since the publication of their Dec 2011 results below

Genterra Trade MoM

What is interesting is the fact Genterra traded very wide of the takeout offer throughout the majority of 2012 and then tightened in significantly for about 6 months through Q4 2012 and Q1 2013 before widening out again. The lesson here being that you should not be afraid to trade your positions although. Again I would caveat that hindsight is a wonderful thing and I imagine I would have held onto Genterra at the end of 2012 if I had acquired it in early 2012 which to takeout would have still yielded me a c. 26% IRR.

c. Monitor Your Portfolio for News Carefully

Genterra released a press release on the 10th July 2015 announcing the takeout. On the 17th July 2015 there was a subsequent Material Change Report (FORM 51-102F3) which was released on the Canadian exchange highlighting the takeout offer.

On the 13th July 2015 1,240 shares traded at CAD$ 1.91. This is a real surprise to me as post the shareholder meeting on the 20th July 2015 a holder of 1,240 Genterra shares will receive CAD$ 1.96 in cash and shares in Genterra Energy independently valued at CAD$ 0.29. My guess is that the seller had not seen the news and rather just saw a higher bid for Genterra stock than they had seen in a long time and hit it. Assuming Genterra Energy trades for CAD$ 0.29 the acquirer of the shares should be a tidy 17.8% return in under a month!

d. Be Patient and Leave Emotions at the Door

Despite considering myself to be a rational person the effect of owning a stock that goes down even though the fundamentals of the company is meeting your underwriting expectations is very difficult to deal with.

I acquired my Genterra position at CAD$ 1.36 in Jan 15 and the stock hit a low of CAD$ 1.21 in Feb 15 after which it recovered to trade in a CAD$ 1.30 – 1.40 range. The fact is that once I bought the stock all I wanted it to do was go up and close down the value gap. I wonder if I had bought the stock in 2012 whether I would have been able to hold onto it for c. 3.5yrs for the catalyst

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Investment memos

Emerson Radio (MSN US) Initiation

Recommendation: BUY, target price $1.40

Share Price: $1.37

Market Cap: $37.2m

Free Float: 43.9%
Ave. Daily Traded Volume: $58,454

Emerson Radio is an ugly company, in an ugly situation and with very ugly corporate governance issues which peaked my interest. My attention was drawn to the stock whilst trawling through The Corner of Berkshire & Fairfax (great investment board if you are not already aware). Unfortunately by the time I got round to doing my analysis I was a month too late to capture the ridiculously low valuation at c. $1.0 per share but I still think it represents good value at these levels and as a result I am adding it as a 5.0% position to the HIPS portfolio.

Background

Emerson Radio is a well-known brand in the US which started life in 1912. The last c. 20 years have not been very kind to the company and it filed for bankruptcy 1993 emerging a year later retaining its listing. In 2006 Grande Holdings, a listed Chinese electronics company, acquired over 50% of the business and started to flout almost all the corporate governance rules in the book. There has been a long history of related party loans and dealings which resulted in various independent board members resigning from the company including the chairman of the audit committee. Grande Holdings filed for provisional liquidation in Hong Kong in June 2011 and is still mired in the process. FTI Consulting were appointed provisional liquidators and up until Feb 2014 had communicated that they would look to monetise Grande’s assets for the benefit of creditors including their c. 60% stake in Emerson Radio. What has transpired as the insolvency has matured is that (i) the vast majority of Grande’s creditors (specifically Sino Bright) have been revealed as related party entities controlled by Mr Ho, the controlling shareholder pre insolvency, and; (ii) the current plan supported by the liquidators is a debt for equity swap and resumption of Grande’s trading on the Hong Kong exchange (more detail on this situation is provided below).

As it stands today there is unfortunately nothing to show that things have changed for Emerson from the bad old days as (a) their effective owner remains the same, (b) Emerson management remains Grande appointees, the board governance is somewhat bolstered by the presence of FTI employees, and; (c) they have retained their auditors despite public censorship of the firm and their relations with Chinese reverse mergers etc. In short “the leopard has not changed its spots.”

Today the company has two key business lines:

  1. Low grade white goods
    1. Their main product lines are micro waves and small fridges which they sell almost exclusively through Walmart & Target who represent c. 90% of their sales
    2. They outsource all manufacturing of the items to c. 3-4 factories in China
  2. License / royalty business for Emerson TV brand
    1. They license the Emerson brand and IP to Funai (listed Japenses net net) who sells flat screen LCD TVs into the US market

Valuation

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I looked that the valuation in two different ways both using low / high cases due to the inherent uncertainty around the tax liabilities. The first was to look at the premium to current market value assuming in one case all the tax liabilities and the other wins on NOPA 1 & 2 and a loss of the dividend claim. As a sense check I looked at the implied net creation price of the Funai royalty stream if all the tax liabilities are all realised and if they are not. My lowest value for the royalty stream is a multiple if 4.0x, in reality given that EBITDA converts 100% into EFCF I imagine the market will value this higher by demanding less than a 25% running cash yield on the market cap. It is worth pointing out that I have not given Emerson credit for its strong positive working capital position which I have detailed above. Even using a liquidation value where you assume they (i) do not recover 100% of receivables due from Walmart, Target and Funai (unlikely), (ii) the inventory & prepaid purchases are fire sold in a car parking lot, and; (iii) any money remitted to the Chinese factories is not recoverable the positive net working capital balance still represents c. 20% of today’s market cap. If the two parts of Emerson were sold on a solvent basis my exclusion of working capital is likely to under value the company.  Finally one criticism you could lay at this valuation is that it does not apply a negative value to the white good business which is currently losing $400k of cash on an annual basis. I assume that any buyer of the business would be able to generate significant synergies which could allow them to take it for at least $1 as opposed to being required to be paid a dowry to take the subsidiary which would represent a downside to valuation.

Getting comfortable underwriting the above assumptions you need to diligence three key areas (i) the tax liabilities, (ii) the licensing revenue, and; (iii) the US white goods business. In addition you have to ask yourself whether you can get comfortable with the controlling shareholder risk particularly given the lack of minority protections in the articles of association and their past track record.

Tax Liabilities

The company has three different tax liabilities that it is fighting with the IRS over.

The first, referred to by the company as NOPA 1 and raised by the IRS in April 2013, relates to the way Emerson’s controlled foreign corporation (“CFC”) in Macao recorded its product sales during FY 2010 & 11 where the IRS is arguing for an increase in taxable income of $5.0m and $5.7m respectively. The company is disputing this claim and has pegged the total liability at $14.9m on the basis that if the IRS is successful they will apply this to the period FY 2012 – 2014 as well. This liability is not recorded on their balance sheet as the company thinks the probability of losing the case is low (will come back to how much reliance you can place on this later).

The second, referred to by the company as NOPA 2 and raised by the IRS in June 2013, relates to the IRS challenging the position Emerson took with respect to the fact that they considered the service fee paid to their Macao CFC to be non-taxable in the US.  In this case the company agrees with the position of the IRS but disputes the IRS’s figures, to date they have paid $0.9m out of an estimated $1.3m liability.

The final tax issue relates to a $1.10 dividend paid in 2010 and was raised by the IRS in August 2012. In determining withholding tax payable the company determined that only 4.9% of the dividend was taxable due a “stock-for-debt” exception. The IRS has outright challenged this position claiming that 100% of the dividend is taxable. The company is defending the claim but should they loose then the IRS will look to claw back tax from parties that received the dividend. This is where it gets really murky as the company originally withheld tax from the dividend paid to foreign shareholders but on request from S&T (controlling shareholder and subsidiary of Grande Holdings) they paid out the full amount in return for an indemnification from future claims in the form of S&T stock in Emerson. In Feb 2011 the company agreed that the collateral arrangement was no longer required. It is unclear why they agreed this as (i) they clearly thought it was required at the time of the dividend, and; (ii) it was way too short a period to be certain the IRS was fine with the interpretation they had taken, usually tax indemnities last of the statue of limitation e.g. 6 years in the UK. If Emerson looses the case and the IRS cannot make recovery from S&T (unlikely as it is in liquidation in Hong Kong and the IRS would be an unsecured creditor) then Emerson could be liable for $4.7m of tax due by S&T. Obviously all of this happened under the watch of pre-insolvency Grande so perhaps to be expected but what is even more galling is that Emerson paid an extraordinary dividend in Sep 2014 and only negotiated a $400k holdback for S&T’s portion of the dividend. Now the optimists would say that this shows that they are confident of their case but in my mind how FTI could have not reserved the full amount when there is an open challenge from the IRS particularly given how complex and uncertain tax issues inherently are is (i) beyond me, and; (ii) shows that even today the majority shareholder, controlled by FTI, is not aligned with the minority holders at Emerson.

Aside from the controlling shareholder I think the tax liabilities are the most tricky part of the Emerson underwrite. I take absolutely no comfort in the company believing that NOPA 1 has no merit as I imagine they are taking advice from their auditors MSPC which have a chequered history at best see (i) (http://pcaobus.org/Inspections/Repor…e_Stephens.pdf, and; (ii) http://www.thefinancialinvestigator.com/?p=166 . That said time has passed since the IRS originally raised the claim and Emerson’s disclosure has stayed the same. The company is spending money defending the claims. In my mind the $4.8m dividend withholding tax claim appears to be a realistic probably as the company originally withheld the dividend and the entity is in liquidation in Hong Kong and unlikely to be able to repay the claim and hence I have showed it in both my upside and downside valuation. The NOPA 1 & 2 claims are much more difficult and therefore I can only “bookend” the outcomes and buy the security at a discount to the worst case underwrite.

Licensing Revenue

Emerson has a licensing deal with Funai Electric Co (6839 JT) to use the Emerson brand name to manufacture and distribute products in the United States. Looking at Funai’s website (http://www.emersonaudiovideo.com/product/index.php) and financial reports their Emerson branded products appear to be exclusively LED / LCD HDTV flat screen TVs.

Emerson’s relationship with Funai is a long standing dating back to 2001 and has been revised a number of times with the latest agreement being inked in Dec 2013. The current form of the agreement stipulates that Funai will pay a non-refundable royalty of $3.75m and a license fee on sales of product in excess of the minimum annual royalties. As it stands the royalty fees on an LTM Dec 2014 basis are $8.7m and have trended up on an LTM basis over the last three quarters from a low of $7.5m.

Funai’s investor disclosures do not provide any breakdown or insight into their Emerson line, however, the vast majority of their sales are TVs (65% of sales) and their key market is the US (82% of total sales). Their total sales have been declining with the best performing category being TV equipment (1.9% decline vs consolidated 6.4% for 9M 2014) and the company is very marginally EBITDA positive. The one good thing offsetting the lack of profitability is that they are extremely cash rich $400m of cash vs $430m market cap.

The authority on US TV sales appears to be IHS which tracks data on a quarterly basis. From their press releases it appears that the US TV market has taken a tumble following robust sales from 2009-11 as people upgraded to flat panel TVs. Peak TV sales were 38m in 2011 with 2012 dropping to 37m (2.6% decline) and 2013 dropping to 34m (8.1% decline). I do not have access to IHS data (it would be great if anyone did) but I imagine you could track the quarterly sales of Emerson branded TVs and work out whether Funai is gaining or losing market share and the general trends in the US TV market which would be very helpful data to accurately value this asset.

I find valuing royalty streams particularly difficult as you could look at them simply as EBITDA which should trade at the same multiple as the company / industry they relate to or as priority revenue streams (such as rent) on income generating assets which should trade at a substantial premium to the underlying industry multiples. A good real life example of the royalty premium is Anglo Pacific Plc (APF LN) which has royalties on 6 producing mining assets, 1 in development and 3 in early stage development. I do not know the company very well but it has traded in the 10-15x EBITDA multiple range over a number of years which is a significant premium to where the miners trade (e.g. Rio Tinto at 5.0 – 7.0x)

For my valuation I am putting a 4.0 – 6.0x multiple on the Emerson royalty stream reflecting (i) the difficult market outlook for US TVs, and; (ii) the lack of buyers (realistically only Funai is going to buy this stream) and using a low and high royalty revenues of $7.5 – 8.7m. If you believe Funai is realistically the only buyer of this stream then you would imagine they would look to pay a discount to their trading price to ensure it was an accretive transaction. Unfortunately as Funai is a net net so multiples are meaningless but looking at peers such as Sony a 4.0 – 6.0x multiple range seems fair.

US Retail Business

Away from the licensing revenue Emerson runs its own electronic wholesale business focused on the US market. A list of their products can be found on (http://www.emersonradio.com/) and are best described and high volume low grade household white goods.

Their two main customers are Wal Mart and Target who account for c. 90% of their sales. Wal Mart has been slowly drawing business away from Emerson most recently cancelling a line of microwaves which accounted for $36.1m (29.7% of total sales) effective from Mar 2013.

As of LTM 2014 this segment had sales of $68.4m and a gross margin of 9.5%. Normalising SG&A for the various one-off items (e.g. legal costs to defend litigation, the majority of which are now finished) the business was EBITDA negative at $417k.

The business is deeply unattractive and has a little to no moat around it with Emerson simply being a middleman for Chinese manufacturers and at the mercy of two very large and powerful price setting customers. I am not ascribing any value to this part of the investment but am also not viewing it as a liability.

Shareholders / Future of the Business

Frankly this is the biggest issue in the trade. The main shareholder S&T Holdings is a subsidiary of Grande Holdings which has been in insolvency in Hong Kong since June 2011. Reading the detailed release on the agreed restructuring plan (http://www.grandeholdings.com/english/investor_announ/20140512_-_ew_00186Ann-(change_of_auditor,_Scheme_of_Arrangement,_etc).pdf) it would appear that the vast majority of creditor claims into Grande Holdings are owned by entities controlled by Mr Ho who was the mastermind behind the previous bad acts (in fact Grande itself has a history of shady transactions in the Hong Kong market dating back to 1999).

The restructuring of Grande had previously envisaged a sale of Emerson which would have been great as the sooner they monetise the royalties, find someone to buy the US white goods business for $1 or greater, and return the proceeds to shareholders the better.

As it currently stands the liquidators of Grande Holdings, FTI consulting, have received a restructuring proposal from Sino Bright on the 2 Dec 2013 and on May 2014 they entered into an agreement with Sino Bright under which all the operations of Emerson (and other divisions) would be retained. Bizarrely in June 2014 the company received a summons to remove the provisional liquidators from Sino Bright which they are challenging. The hearing of these summons have been delayed to the 16 November 2015 and it is not clear whether the liquidators have fallen out with Mr. Ho or whether the application to remove FTI was bad faith or general negotiating tactics.

Interestingly as part of the restructuring proposal the Ho connected entities have offered a 60 cents cash alternative to independent third party creditors equitising their debt into new shares which will resume trading on the Hong Kong exchange. As part the disclosure the total claims pool is HK$ 3,177m which will equitise into 90% of the post dilution share capital. As a result the Sino Bright cash out offer values the group at HK$ 2,118m or $273m at today’s exchange rate.

Taking the Dec 14 results of Grande Holdings (http://www.grandeholdings.com/english/investor_announ/ew_00186ann-31032015.pdf) you can do some work to try and backsolve the value of the group and see if there is any read through to Grande’s view of Emerson’s value. Today Grande consists of two business lines (i) Emerson, and; (ii) a licensing business focused on the Akai, Sansui and Nakamichi brands. Leaving Emerson to one side the licensing business has revenues of HK$ 55m and segment results of $39m.

There is HK$472m of cash and I am assuming all other assets on the balance sheet represent working capital or other non monetisable assets. I am also assuming all liabilities are wiped clean in the debt for equity swap.

Subtracting the HK$ 472m of cash from the implied “market cap” of Grande leaves you with a value of HK$ 1,646m. If you value the royalty business at a high multiple of 8.0x (HK$ 312m) you are left with a value for Emerson in the mind of Mr Ho of HK $1,334m or US$ 172m which is substantially higher than today’s trading price and implies a EBITDA multiple on the royalty stream of 15.6x assuming all the tax liabilities are defeated. Another way to look at this is that Mr Ho is paying an implied HK$ 1,646m for HK$ 74m of EBITDA or c. 22x (in reality it is likely that Grande normalised EBITDA is higher as their administrative expenses are likely bloated by liquidators and legal fees). I am not taking a huge amount of comfort from this but spent time on it as it is both interesting and also directional that Mr Ho is willing to offer $25m of his cash to clean out Grande creditors at a 60c on the dollar price.

Reading the disclosure it seems that the next hurdle is getting approval from the Hong Kong listing authority for a resumption of trading on the exchange and then a full release of a shareholder circular detailing the plan. Timetables in liquidations are always tricky and the release of the circular has been delayed now for over c.12 months vs the original estimated delivery time.

Getting full details of this restructuring and also seeing the plans for Emerson is clearly the next major catalyst for the stock with the currently deadline announced by Grande as the 30 April 2015.

Recommendation

Emerson is not for the faint hearted. However, I think you are being paid for the risks particularly as in a liquidation scenario assuming (i) no value for the royalty stream, (ii) full tax liabilities, and; (iii) the liquidation value of the working capital you would recovery 75% of the current market valuation. As is so often the way when the stock was trading at the lows of $1.0 it was disgustingly cheap and I would have made it a 10% position in the HIPS portfolio but today I still think there is a lot value to be had and am willing to add at these prices and hope that the share price goes lower. The clear catalyst for price action is progress to the relisting of Grande’s equity and settlement on the outstanding tax claims.

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