Investment memos

Gencan Capital Inc (GCA CN) – Smash & Grab 1.85x MoM – SELL above CAD$ 0.043

Our relationship with Gencan was even shorter than with it parent and listed predecessor Genterra Capital Inc (original memos can be found here & here). We exited our entire position at CAD$ 0.14 on the 11th November 2015

A quick potted history of the situation as a reminder for those who have not read all the previous posts:

  • Genterra Capital Inc was a Canadian Venture listed company which owned real estate, a solar park and some listed securities
  • On the 10th July 2015 the controlling shareholder made an offer to take Genterra private in the form of cash consideration of CAD$ 1.96 per share and two shares in Gencan Capital Inc an entity being spun out of Genterra which would own the solar asset
  • We exited our Genterra position in the market on the 4th August 2015 at an implied price for Gencan shares of CAD$ 0.195 which implied the market was paying a premium to the undiscounted cash flow streams of the solar park which is mad
  • We then got the opportunity to re-enter Genterra with a view to creating the Gencan spin-off cheap and acquired shares at an all in effective price of CAD$ 0.745 between the 14 & 16th of August 2015
  • The Gencan spin-off became effective on 28th October 2015 and the shares were listed to trade on the Canadian Securities Exchange as of the 30th October 2015

At the time we initiated the trade there was imperfect information on Gencan which had previously been a subsidiary of Genterra and therefore did not have separate reporting as well as having only limited trading history given it only recently started generating electricity as of August 2014. At the time of trade the majority of our information came from the Genterra takeover prospectus and the accompanying valuation report. Since then there has been additional disclosure specific to Gencan Capital Inc on sedar which revealed the following:

  • Rent – confirmed that Gencan has to pay rent to Genterra for the lease of the rooftop which equates to CAD$ 60,000 per year for 20 years (the life of the FiT). They also have a 10 year extension option in their favour (we assume to capture repowering opportunities)
  • Administrative Services Agreement – revealed that on top of the CAD$ 60,000 management fee Gencan would pay to Genterra it would also pay an annual CAD$ 6,000 administrative services fee
  • Overall Operating Expenses – the company is estimating CAD$ 270,000 of annual operating expenses (including interest)
  • Results – on the 5th November 2015 Gencan released its June 2015 9 month results which showed that if Q4 produced a similar amount of electricity as Q3 which would seem sensible given it covers the summer months of July – September then the company would likely hit its revenue target
  • Debt – nasty surprise here that the debt is due on 1st August 2019. Our assumption had come from page E-2 of the Genterra information circular where the independent valuer stated that “A loan from Genterra was used to finance the installation which bears interest at 4% and is assumed to be paid in five instalments of $511,594 on 30 September for the years 2030 to 2034.” On closer examination of the same document on page G-20 they state “Pursuant to an Amending Agreement made on July 16, 2015, the loan has been converted into a 5-year term loan repayable on August 1, 2019, with interest at a rate of 4% per annum calculated and payable monthly in arrears.” Why the valuer was using a different assumption from reality we have no idea but more fool us for not reading the document more carefully

Incorporating all this new information into our model we come to two key conclusions that you need to draw when valuing Gencan today:

  1. The total cumulative net cash flow to equity is likely to be in the range of CAD$ 2,677,286 (depending on your debt repayment assumptions)
  2. Given the 2019 debt maturity it is unlikely that Gencan will make any distributions to the equity until after the maturity as the business looks to build up cash to delever

In terms of valuing Gencan we have changed our base case to reflect the changes above and also show a build-up of cash until 2019 and then a repayment of the debt via a 100% free cash flow sweep. Only once the debt is repaid can you expect equity distributions. This is in-line with project financing agreements for similar solar park ventures that we have seen elsewhere.

We would sell our position in Gencan at an Equity Free Cash Flow (“EFCF”) yield below 10% (implied price of CAD$ 0.043) and start adding if the EFCF got above 15% (implied price of CAD$ 0.024). As a result we exited our position at a price of CAD$ 0.14 for a 1.85x MoM and a 413,575% IRR.

Updated model below

Gencan Capital Inc Memo (2015.11.15)

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Investment memos

Gencan Initiation

Recommendation: BUY, target price upto CAD$ 2.17 (including trading costs)

Share Price: CAD$ 2.15

Market Cap: CAD$ 17.9m

Free Float: 28.9%

Ave. Daily Trade Volume: CAD$ 1,288

This investment comes out of our previous involvement in Genterra and is focused on creating the spin-off entity Gencan at a reasonable return on equity over the life of the solar feed in tariff. We have written extensively about Genterra during our hold period and the key post describing the spin-off entity and how we value it is here.

Last week we loaded up on Genterra securities as they represented an excellent return on contracted cash flow. In creating the position we had to factor in the following two considerations:

  1. Position sizing post the demerger dividend – at the top end of our buy range only 10% of capital deployed will remain as the final position in Gencan. Obviously if we achieved better pricing than CAD$ 2.17 our stub position would represent an even smaller % of capital deployed.
  1. Trading fees – when creating the stub position for a maximum price of CAD$ 0.21 you have to be very sensitive to the effective creation price including your trading fees which changes depending on how many shares your purchase per trade (i.e. how spread out your fixed trading costs are). As a result of these factors it made sense for us to acquire 510 shares at CAD$ 2.0 which created the company to a 39.1% IRR in our downside case but if we have acquired 510 shares at our maximum buy price of CAD$ 2.17 our IRR would be only 10.9% which is below our target price of 15.0% IRR

Included below is an overview of how we calculated target trading levels depending on the amount of securities that were offered in the market

Genterra Trade Sizing

On the question of sizing we think this is very good risk as you are acquiring a fixed set of cash flows that have been set by the government with the energy being taken by the government (Ontario Power Authority). The only way for these cash flows to change would be by operation of law as you have seen in Spain which we see as unlikely to occur in Canada. As a result in the rosiest picture you could argue that you are buying a proxy for Canadian sovereign risk significantly wide of where their long dated bonds which trade at a Yield to Worse of 2.27% (unfortunately for what we can see Canada only have 21 sovereign bonds out and the longest maturities are 2021 and 2064 so we chose 2064 as the length of the contract goes to 2034)

We would have liked to have Gencan be a 7.5% position in the portfolio but mathematically we would have had to deploy more cash than we have available in the fund. Instead we took the view that we would deploy all our available cash less 7.5% in case we stumbled across another position we really liked. We expect the spin-off transaction to consummate before year end and to be left with a 5.7% position based on total net portfolio value as of Q3 2015.

In total we completed the following trades last week taking us to a full position size:

Gencan Completed Trades

Our net Genterra creation price of CAD$ 2.109 creates Gencan at a 22.5 – 26.9% IRR to renewable tariff expiry in 2034 and if held to maturity would represent a 3.9 – 4.6x MoM from contracted cash flow.

As with all investments there are risks which we split into pre & post spin off below:

  • Pre Spin-Off – up to consummation of the transaction we will have 80.7% of our fund in Genterra which is scary. We got comfortable with this risk as the transaction is being proposed by the 70% shareholder so the risk of the conditions precedent not being fulfilled is low (our guess is that tax clearance is potentially the only element not in their control). We also get comfortable with this concentration given our view that the controlling shareholder is acquiring Genterra at a significant undervalue vs our CAD $2.90 a share valuation of the enterprise. Finally the nature of the business (real estate and renewables) is very stable so the chance of a material adverse change in the business seems low
  • Post Spin-Off – we are faced with the same risks as we had when we invested in Genterra namely: (i) illiquidity of the security, (ii) controlling shareholder leaking value to themselves, and; (iii) poor capital allocation. Given our approach and focus we are inherently comfortable with risk (i) as it is the main driver of opportunity creation in our universe. We are more comfortable with risk (ii) as the controlling shareholder did conduct a valuation and got court approval for their take private of Genterra, however, we will just have to accept that if this happens at Gencan it will be at an undervalue and that the cost structure of the vehicle will not be optimised (which we reflect in our model). Finally we are probably most concerned with (iii) as the controlling shareholder may decide to use cash generated by the entity to invest in new solar projects at lower equity returns to either help with related party transactions or grow their fee base which would obviously dilute our return

Our model of Gencan can be found below:

Gencan Memo (2015.10.24)

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