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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Track Record

HIPS Performance Track Record (Q3 2015)

HIPS Performance Tracker Q3 2015

We continue to be disappointed with how much time we are actually spending on security selection and the blog which is reflected in the fact that 9 months into the blog we have only deployed 12.5% of our assets.

In the quarter we monetised Genterra Capital Inc after the owners made a combined take private and spin-off bid for the company. Whilst we were very disappointed with the clear undervalue the take private offer represented we were able to exit in the secondary market at an implied valuation of SpinCo that was ludicrously high and generated a profit of 72.8% / 1.72x MoM and an IRR of 162.3%.

Despite only deploying 17.5% of our portfolio at the peak we are up 2.8% net of costs for the first nine months against (1.8)% for the passive portfolio which is 95% invested.

Jubii Europe has reached the buy price we set in our previous article and we intend to revisit that security in the near future. In the meantime we have summarised developments during the quarter for our holdings below

Emerson Radio (MSN US)

We increased our position in Emerson to 7.5% of the portfolio post the late release of their 10K as: (i) the major risk of a negative outcome on the IRS tax investigation had been removed with Emerson achieving a positive outcome vs our case, and; (ii) the stock was trading below our entry price despite this positive news. Emerson’s main issues remain the underperformance of their white goods business and the resolution of the restructuring / liquidation of Emerson’s major shareholder, Grande Holdings, couples with the potential for bad acts by the controlling shareholder.

Since increasing our position Emerson released its June 2015 quarterly results in August which highlighted two areas of concern. The first relates to the profitability of their white goods business post revenue decline of 26.4% in the quarter which was in excess of management’s expected 15.0% decline due to discontinued lines by their customers. We had previously highlighted a concern that with lower customer orders Emerson may not benefit from the same competitive pricing from their suppliers that they were able to achieve on a higher order volume. This concern would appear to be being borne out by the fact that gross margin declined to 7.0% which is the lowest level since Q1 2014.

However, a much larger concern around the white good business is that Emerson management have actually increased their SG&A vs Q2 2014 by 11.2%. This is absolutely staggering and really needs to be addressed as the business is clearly in decline and now EBITDA negative. We remain of the view that the company should sell its white goods business or at the very least cut costs to the bone.

The second issue that is concerning us is that despite a large decrease in revenues trade receivables actually increased by $5m. It is also surprising that inventories have remained flat. We have stated in the past that the Emerson white goods business has a significant positive working capital balance (now $22.1m) and we would expect to see cash released as the white goods business declined. We hope this is just a timing issue as if not it would further point to the poor management of the business by FTI, the board and the executive management team.

Looking at the filings of the Grande Holdings liquidation they are still in the same dance of a perpetually delayed publication of their restructuring circular which is concerning as the restructuring is supposed to be wrapped up by December 2015 (seems very unlikely). As discussed before the process is very opaque and the controlling creditor / shareholder has engaged in questionable dealings both with Emerson and Grande so we will just have to keep close eye on developments.

Our updated fair value range for Emerson is $2.38 to $2.95 which ascribes no value to the white goods business and assumes the full $4.8m of dividend tax liabilities. Acquiring the stock today at $1.23 you are getting the valuable licensing business for free as the estate trades below cash. Furthermore even if you run rate Q2 2015 negative EBITDA from the white goods business and assume no working capital benefit the operating free cash flow yield would be c. 12.5%. We believe the investment thesis remains intact but will closely monitor developments at Grande as well as management actions at Emerson.

Caltagirone SpA (CALT IM)

The only major update in this story is that FCG Finanziaria, a holding company of Francesco Gaetano Caltagirone, made a takeout offer at €6.8 per share for the remaining shares of Vianini Lavori not owned by the connected parties of the Caltagirone Group. It has been recently confirmed that they have got to the 90% threshold in order to delist the company and will proceed to do so.

FCG’s offer represented a 16.5% premium to the last three months trading price but is still a 41.9% discount to our view of fair value (which does not give any value to their construction business).

Included below is our valuation of the Caltagirone complex both at investment date and as of Q3 2015 which shows that the only meaningful moves in valuation have been: (i) the increased market price of Vianini Lavori, and; (ii) the share price of Caltagirone SpA.

Caltagirone SpA Value Evolution

Caltagirone Editore SpA (CED IM)

Since our investment the CED IM’s discount to fair value has increased by 3.3% despite the underlying performance of the business significantly improving. In Q2 2015 the business posted positive EBITDA of €1.3m vs a loss of €0.4m in Q2 2014 representing an overall profitability improvement of €1.7m vs a similar improvement of €1.2m in Q1 2015. These improvements have meant that the business has moved from a €3.7m cash burn in H1 2014 to a €1.9m cash generation in H1 2015 which is a sterling effort.

The negative is clearly that revenues continue to decline with the positive performance in EBITDA being driven by continued cost cutting. Whilst CED IM’s online revenues are increasing strongly (11.5% increase in the quarter) we expect the need to see revenue stabilisation to see a real re-rating in the stock.

Hopefully the Caltagirone family will look to take advantage of the clear mispricing of CED IM in a similar way to Vianini Lavori although obviously we would hope it is at a price which more closely reflects fair market value.

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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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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

Genterra Capital Inc (GIC CN) Initiation

4th January 2015

INITIATION – BUY upto CAD$ 1.45 per share

Share Price: $1.31

Market Cap: $10.9m

Free Float: 55.4%
Ave. Daily Traded Volume: $450

Discount to Fair Value: 64.4%

Background

Genterra describes itself as a “Southern Ontario based private equity investment firm that targets North American industrial products, services and real estate that can benefit from the Firm’s operational expertise.”

The company was formed from a merger of Genterra and Consolidated Mercantile in 2009 and is majority owned by Fred Letwin and his family who have multiple interests away from the company

Today the company consists of cash on balance sheet and five industrial properties in Canada

Recommendation

Buy Genterra up to a price of CAD$ 1.45 per share.

At the current price of CAD$ 1.31 you are creating the company for a c. 26% discount to net cash & marketable securities and creating the CAD$ 22-24m of property value as well as other assets worth CAD$ 2.7m for free

The equity free cash flow yield (excluding WC fluctuations) is currently 5.8% and has only been negative on a rolling last twelve month basis in one quarter (Sep 2012) since the company. We see this as reducing the risk of your margin of safety being eroded and allowing you to hold onto the asset for a long time

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

Assets

The company has the following assets on the balance sheet as of June 2014

  • Cash – CAD$ 18.9m
  • Marketable Securities – CAD$ 4.1m
  • Real Estate – 19.2m of real estate (balance sheet value, market value is higher)
  • Loans to Third Parties – CAD$ 2.7m
  • Total – CAD$ 45.0m

Cash consists primarily of investments in short term deposits that are either cashable or have maturities of three months or less

Marketable securities consist of both Level 1 (45%) and 2 (55%) financial assets. They are primarily investments in hedge funds

The real estate consists of five properties across Canada the majority of which are industrial properties. They are carried on the balance sheet for CAD$ 19.2m vs a fair market value based on the company’s estimates of CAD$ 21.5 to 24.2m based on cap rates on the buildings of 5.25 – 9.25%

Loans to third parties consists of CAD$ 1.3m related to the loan provided to Highroad Estates (related party) for the installation of solar equipment on Genterra’s properties. This loan attracts 4% interest per annum and matures in Jan 2017. The remainder relates to three historic loans secured on property bearing interest rates of 5 to 8% and maturing in H1 2016

The CAD$ 0.6m relates to installation of solar energy generation equipment that the company has agreed to install (total expected cost of the installation is CAD$ 2.2m). It is not clear how the company is being compensated for this equipment

Liabilities

Genterra has the following liabilities on its balance sheet

  • Mortgage debt – CAD$ 8.2m
  • Retractable preference shares – CAD$ 4.9m

The mortgage debt relates to two of Genterra’s properties and is amortising with maturities in 2017 & 2018 for a bullet repayment of CAD$ 7.6m

The retractable preference shares are owned by First Ontario Investments which is controlled by Fred Letwin and are redeemable for cash at the option of the holder. There are 326,000 preference shares which are redeemable at CAD$ 15.0 and have an 8% interest on the face value. They are also convertible into 5.56 common shares (1,812,560) or 300 Class B preference shares (97,800,000)

Valuation

At CAD $ 1.31 per share the market capitalisation is CAD$ 10.4m based on current outstanding common shares of 8,314,358.

Cash and marketable securities less mortgage debt is CAD$ 14.8m. Adding the real estate (at balance sheet carrying value) and loans to third parties which total CAD$ 22.0m results in an Enterprise Value of CAD $ 36.7m

At a TEV of CAD$ 36.7m the value of 1,812,500 common shares is CAD$ 6.7m vs a current face value CAD$ 4.9m and the holder of the retractable preference shares should convert as a result which takes the total common shares post dilution to 10,126,918 and a diluted price of CAD $ 3.69

Assuming a holding company discount of 20% (debatable and addressed in a separate article on this site) the shares should be worth CAD$ 2.90 which represents a margin of safety of 64.4% and a clear buy at current levels

Related Party Transactions

70.6% of the outstanding common shares are owned by entities controlled or indirectly controlled by Fred Letwin and in one case a company (Sutton) owned by the children of Fred Letwin

There are a very large number of related party transactions within Genterra, namely:

  • Administration & management fees – Forum financial, a company controlled by Mr Letwin provides the services of Chairman, CEO and CFO for an annual fee of c. CAD $ 800k. The company did not pay any remuneration to key management as a reuslt
  • Property management fees – c. CAD $ 200k are paid to First Ontario Investments
  • Retractable preference shares – are owned by First Ontario Investments
  • Solar Generation – Genterra has entered into agreements with Highroad, the holder of Solar Energy Feed-In Tariff Program Contracts for two of Genterra’s buildings. In one case Genterra has made available to Highroad a 3yr term loan of CAD$ 2.3m to buy and install solar equipment on the Wendell Avenue property. Once complete Highroad will pay an annual lease of CAD$ 60k per year in addition to repaying the loan. On the second project Genterra is acquiring and installing the solar equipment on the roof of its Dobbie Drive property at a cost of approximately CAD$ 2.3m and once complete this will be managed by Highroad. Certain directors and officers are also directors and officers of Genterra

Whilst there is nothing improper about any of these transactions (to the best of our knowledge or investigation) they do represent a poor management of the assets from the view of the minority shareholders. If HIPS were in charge of running the company we would:

  • Redeem the retractable preference shares at CAD$ 15 – (i) the value of the equity is worth more than the face value of the shares and (ii) keeping an 8% running interest is inefficient given the company has cash on the balance sheet and with reference to financing rates available in the market
  • Initiate a share buyback programme – with excess cash on the balance sheet and a stock that is undervalued by c. 70% (excluding preference share conversion dilution) to the underlying assets it is difficult to see a use of cash that is more value accretive on a risk adjusted basis
  • Invest excess balance sheet cash – it is inefficient to hold such a large amount of cash on the balance sheet and it should be deployed into investments should share buybacks no be forthcoming at a sufficient rate
  • Investigate the rental real estate operating costs and administrative & general costs – real estate operating costs are currently running at c. 50% of the rent. This seems excessively high vs other real estate companies HIPS examines and could be explained by a number of factors. We would examine carefully savings another buyer could extract and see if a greater value could be achieved through selling the property. It is unclear to us whether minority shareholders are getting good value (from a cost perspective) from the management services provided by Forum
  • Investigate the economic deal and credit quality of Highroad – we would want to understand first the credit quality of Highroad as Genterra has lent money to them. Equally important we would want to compare the management costs, rent payable and equity returns achieved by Highroad. It would not be acceptable for Genterra to lend to Highroad the total cost of the solar project on Wendell Avenue for Highroad to be able to payoff the loan in three years from cash flow (after rent) and then enjoy outsized equity returns for the remaining life of the project

It is obvious to us why the preference shares have not been redeemed given the related party ownership. The high costs could be explained by either (i) high costs charged by related parties (if so these do not show up in disclosure) or (ii) nature of the properties or operations mean these are the true optimised costs. We do not know the economics or returns of the solar generation projects so cannot comment. Finally, we cannot understand why management is not buying back shares or investing excess cash.

All of these things are a worry and we have seen the danger of being a minority in the case of Beaumont Select Corporation (see other article). All of that said the discount to fair value and the positive FCF yield despite all of the above make this a buy but require it to be sized more conservatively than other stocks presenting such clear value propositions

Stock Liquidity

Genterra’s stock is extremely illiquid. 70.6% is held in concentrated hands of effectively one holder and the remaining 2.4m shares trade seldomly.

Over the last two years 294,714 Genterra shares have traded representing 3.5% of the total share count and 12.1% of the non-connected shares

Illiquidity is not a bad or good thing but combined with the related party transactions meaning the company is not being run to maximise minority shareholder value limits our portfolio position size to 5.0%

Where Could We Be Wrong

We see the biggest risk to this investment being related party transactions and the risk of value leakage to certain shareholders at the expense of the minority. The actions of the majority shareholder over time has not demonstrated any major red flags but they have multiple other interests meaning the risks that their interests are not 100% aligned with the minority shareholders is higher than usual

The other key risk is counterparty and letting risk on the five Genterra properties. For example one tenant (we think the Cambridge Towel Company) is the sole occupant of two of Genterra’s properties accounting for 21.3% of total rental income relates. Their lease on Glendale Avenue was due for renewal in 2014 and was not renewed. Whilst it only accounts for 4.5% of Genterra’s rental income it highlights the risk of non-renewal and also the cost to re-let given significant tenant specific modifications that were required at the site. The lease on the other property, Dobbie Drive, expires in 2017.

Useful Information & Sources

SEDAR – provides all the regulatory and results releases for Genterra (http://www.sedar.com/)

Colliers – quarterly research reports on Toronto area industrial real estate market (http://www.collierscanada.com/en/Commercial-Property-Research)

HIPS memo – Genterra Inc Memo (2015.01.04)

p.s. if anyone knows a source where you can access private company filings for Canadian companies (similar to UK companies house where every company must file and annual report) we would be very grateful to know

Outstanding Questions for Genterra

Making sure that the B shares have no economic value / voting rights

Clarifying the exact terms of the High Road solar deal

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