The closing sale for Davis and Henderson

I’ve written a little bit about D+H Corporation (TSX: DH) in the past. On March 13, 2017 they received an all-cash buyout offer for CAD$25.50 from an international firm and there is no reason to believe this will fail.

In my opinion, DH shareholders are getting a good deal since there are plenty of storm clouds on the horizon for the company.

However, there is a lesson for me in this story even though the last time I owned shares was in 2010.

Back in October 2016 when they released their disaster of a quarterly earnings report, their stock subsequently traded as low as CAD$14.06, although realistically if you had started accumulating after their earnings disaster you would have received an average price of around CAD$15/share. I also predicted the company would slash its dividend in half (which it nearly did, from 32 cents to 12 cents a quarter) and thought the stock would get hit even further as I projected a spiral of selling by panicked investors.

This did not happen. Instead, when they announced their dividend slashing, the stock quickly went up to $16 and never looked back. The company announced a strategic review to sell out the firm on December 7, 2016 which sent the stock up to $21/share and you can see the rest of the story in the stock graph.

So in the span of six months between an earnings disaster and the buyout offer, the company’s stock price has appreciated by a factor of 70%.

In retrospect, the October quarterly report and subsequent dive in stock price (from $28.70 to $16.20) should have been an equity purchasing event, not an event to continue throwing eggs and rotten tomatoes at the corporate body.

It makes me wonder about my valuation methods and why I got this one incorrect.

I wasn’t in a very good position to invest back in October 2016 (I was mildly leveraged at the time), but even if I was in more of a cash situation I probably wouldn’t have dipped my toes until around CAD$12/share where I would have seen an acceptable risk/reward ratio.

I have performed equity and debt research on hundreds of companies. Some companies I keep current on even though I have not taken a position on them. Some companies I just look at once and don’t look at them again until years later when there is some reason for them to show up on my radar again. There are also some like D+H that I have invested in a long time ago and check in from time to time. Whenever companies like these appear again, there is always the knowledge that I have done my due diligence over a larger period of the company’s history compared to those that are freshly looking at the company. In the case of D+H, it will be sad to see this accumulated research knowledge go away, but that is life as an investor in publicly traded securities.

D+H Corporation slashes dividend

I looked at D+H Corporation’s (TSX: DH) last disaster of a quarter and predicted the following:

My guess is that the dividend is going to get slashed in half.

So, today, they announced their 32 cent dividend is going down to 12 cents. The stock is up today because the company says they are going to do a share buyback with half the amount that they wouldn’t have paid out in dividends, but given their leverage situation, I’d be skeptical.

Looking back at Davis and Henderson

Once upon a time, I had invested some money in David and Henderson Income Fund, which was back in the days when a lot of viable corporate operations were structured in the form of an income trust. I made some reasonably quick capital gains, sold, and never looked back.

Davis and Henderson, similar to Kentucky Fried Chicken, Ernst and Young, PriceWaterhouseCoopers and many other establishments, decided to abbreviate their corporate name to their initials and become D+H Corp (TSX: DH). Considering that their previous business was the printing and processing of Canadian (paper) cheques, diversification of their business was correctly considered and for the most part, they made a fairly good transition into the broader realm of providing financial technology services for big banks.

You can see in the 10-year chart that this has really worked for them, and the market has been on their side, until recently:

dh

What you don’t see is that in today’s trading, they fell 43% on a quarterly announcement (closing at $16.25/share, with a low of $14.97), bringing their stock price to levels frighteningly close to what I had invested back in 2010 with a cost base of $16.10 per unit. This was certainly a case of “back to the future” for Davis and Henderson.

The question of course is whether the six or so years it has been since I had last invested in them, whether they were worth taking another stab at again.

D+H’s fateful decision was the acquisition of Fundtech on March 30, 2015 (which closed a month later). In this acquisition, they issued many hundreds of millions of debt (in addition to doing a secondary offering at $37.95). Unfortunately, while the acquisition was designed to represent a diversification away from their traditional businesses, it has not materialized into anywhere that could be financially rationalized with the price paid. It has also bloated D+H’s balance sheet with the haunted scars of an additional $1.7 billion in goodwill and intangibles, and when considering their pre-existing goodwill and intangibles, they are sitting on a negative $1.3 billion of tangible equity.

Putting this into plain English, their balance sheet is a train wreck.

Train wreck balance sheets can only sustain themselves with positive cash flow, and continued good credit, as the generosity of lenders will be able to see them through.

For the first 9 months of the year, they have generated $167 million in free cash flow. A majority of this goes to dividend payments ($90 million), and the rest of it goes to debt repayment and acquiring other intangibles.

The problem is with the last quarterly result – it is quite evident that the corporation, on a consolidated basis, has flat-lined. While they still generate a very healthy amount of cash, it is obvious that they will be receiving future stress in the form of being able to repay debt as it matures.

They face the following debt situation:

dh-debt

They have an immediate maturity coming in June 2017, which they should be able to pay off with existing cash flow and/or their revolver without issues. The issue is what happens when they start getting into the bulk of their 2021-2023 maturities.

The math is simple – if they continue paying dividends at their current rate, they will have about $100 million a year in cash to acquire businesses (more intangible assets on the balance sheet) plus debt repayment. They will not have nearly enough to pay off the bond maturities without getting another extension of credit from bondholders.

Considering all of the bond issues and the revolving facilities are secured debt, you can be sure that the banks that supply the revolving debt are going to be nervous about using their money which is pari-passu to bondholders – which means that something is going to have to be negotiated in a couple years.

My guess is that the dividend is going to get slashed in half.

In terms of valuation, the balance sheet situation would make me quite uncomfortable as an equity investor. While I see the value in the cash generation potential of the underlying businesses (notwithstanding the fact that cheque processing is a dinosaur industry and is decreasing accordingly), I do not believe a leverage-adjusted valuation of this business is attractive at present prices.

For now, D+H is still a “pass” in my books. I did sell them at $21 back in the year 2010.

Davis + Henderson – Valuation

Markets indeed move quicker than most anticipate, and I can say the same for the common shares of Davis + Henderson (TSX: DH) as I have unloaded them today for a mild profit. Readers may recall my entry into the former income trust units, and partial sale in October of last year.

I have no concerns with the underlying business – although I have concerns with the speed of their acquisitions – it assumes that management can execute on proper integration. The balance sheet of DH is less than stellar, with about negative $224 million in tangible equity, but their debt levels (about $200 million in low cost debt) is manageable in relation to their cash flows (due for about $100 million after CapEx in the 2010 year). They will be giving off about $100 million in distributions to income trust holders in 2010, however. In 2011 the situation will change somewhat as they reduce distributions by 35% and will also incur an income tax (which will cut their cash flows by about 27-28%).

Most people will look at the headline yield number (roughly 5.8%), but the company should be evaluated on cash flow generation rather than the dividends they give out. On a free cash flow basis, they should be generating about $75 million after the trust conversion or about $1.39/share. Given their share price, this works out to a P/E of roughly 15, or a 6.7% combined yield. It is a healthy valuation considering the various businesses they are involved with.

The capital will likely be better invested in other options throughout the year but presently the pickings are slim on the Canadian side. I suspect 2011 will involve a lot of waiting.

It wouldn’t surprise me to see DH go up to $23/share if they show they have executed well on their acquisitions, but I’m happy to get out now – my initial valuations were also somewhat fuzzy since I don’t have a full comprehension of their industry. Most of the gains from the price they traded at after they did their corporate conversion plan have been realized with the existing stock price. No point in getting greedy right now.

Davis and Henderson fooling all sorts of investors

The award for the “most botched up trust conversion of the year” would have to go to none other than Davis + Henderson. This is ironic since they are a business service company that would presumably include assistance with such things as income trust conversions.

Previously their ticker symbol was DHF.UN (on Toronto), but they changed their ticker to “DH.TO” upon conversion.

An additional mixup is that DHF.TO traded 104,000 shares on January 4, 2011 under the wrong ticker symbol.

It is most likely that somebody botched up the paperwork because most electronic systems still have a listing for “DHF.TO”, which is not the proper symbol and is not trading. The correct symbol, “DH.TO“, is listed on the TSX but has had negligible volume because almost everybody’s electronic systems (including Interactive Brokers!) have the improper DHF.TO ticker.

Disclosure: I currently have a position in Davis + Henderson.

A relatively quick trade

I am now slowly unwinding my trade in Davis + Henderson Income Fund (TSX: DHF.UN). If the units go higher by approximately 5%, I will be exiting the entire position compared to the partial sale of my position as of this writing.

While I do not have concerns about the stability of their distributions (especially as they will be reduced 35% or to $1.20/share after they convert to a corporation), I do have concerns about the ability of management to grow the company’s free cash flow from existing levels. They have been pursuing a strategy of growing revenues and income through acquisition, which is generally a risky method compared to growing organically. So far, it has worked for them. The question is whether it will continue to doing so – which is never a given.

This company is not unique at all in the income trust sector to being bidded up. All sorts of income-bearing securities are becoming very expensive.

Although DHF will pay 5.85% a year (at 20.50 per share) in eligible dividends in 2011 when they convert to a corporation, I do not think this cash stream is worth paying the current price for given other investment opportunities – none of which give yields.

What I find interesting is it is likely retail investors that will be focusing on the 5.85% yield instead of looking at the underlying business and asking what they are purchasing. I am not complaining – I am taking this opportunity to take some more of my portfolio off the table and holding yet even more cash for future deployment.

The net gain is approximately 25% above cost basis; not factoring in the few distributions that occurred between the purchase price and the disposition, not bad considering that the upside is more limited than the downside.

Davis and Henderson purchase – Corporate conversions from income trusts

Income trusts are starting to announce conversions to corporations and the effects on their unit/share prices are quite telling. For profitable companies, they will have to announce distribution/dividend cuts to compensate for the effect of the upcoming tax on trust distributions.

Davis and Henderson is a business services company, doing about $482M in revenues for 2009. They are primarily an acquirer and consolidator of smaller companies and they have been fairly good at streamlining synergies with these acquisitions. Their balance sheet is messy (negative $235M in tangible equity, little cash and about $200M in revolving term loans as debt) but they generate hefty cash flows. They also distribute, just like most profitable trusts, the vast majority of their free cash flow. However, they pass my ‘trust test’ which is that they generate more in net income than they distribute in cash.

They announced that they will be converting to a corporation and with it their distributions will be going from $1.84/unit to $1.20/share in 2011 because of the tax impact. This is a 35% reduction in distributions and they rationalized the 64 cent cut by saying that had they been a corporation in 2009, they would have had to pay $0.60 to $0.66 in taxes. Their communications person must be a good spin doctor since they didn’t mention that the projected tax would effectively have to be paid on a larger income amount than $1.84/share – after backing out the intangible amortizations, the company generates about $2.27/unit in cash and a 28% corporate tax take is appropriate. In addition, the corporate tax rate will be dramatically decreasing in Canada in 2010, 2011 and 2012. In 2011 it will be 16.5% federal, and roughly 11% provincial, while in 2012 it will be 15% federal and roughly 10% provincial in the major jurisdictions (BC, Alberta, Ontario).

The point is that the distribution cut is going to be more than covered by the company’s cash flows, and they can use the surplus to pay down debt and reduce leverage on their balance sheet.

I know how a lot of retail investors think, and whenever they see a dividend cut, they will panic and sell. So that, they did:

Trading instinct is a difficult thing to describe, but since I’ve been stalking Davis and Henderson for quite some time now, I knew this would be a good time to pounce. When examining their release and annual report, I estimated investors will take down the stock between 5-15% for the day, so I layered an order to buy shares continuously between 6-12% and got enough of a fill to get a 3% position in the company – I was prepared to take 6%, so this was better than nothing. The low for the day was 8.8% below the previous day’s trading price. As you can see, institutional investors and myself likely cashed in on the retail panic.

People that are not in the upper tax bracket can receive Canadian dividend income virtually tax-free. Starting in 2011, I will be getting about 7.6% “tax-free”, and this should be a sustainable yield on my investment given the financial state of the company and the relatively boring businesses they are involved in. The largest risk to this company (other than the slowdown in the business services they are involved in that will exhibit a natural decline, such as cheque-printing and processing) is rollover risk of their $200M term loans. They can equitize the debt with about 19% dilution to existing holders and the history of the company suggests that their relationship with the banks are stable and it is unlikely we will see an attack on their equity by hedge fund artists that want to bet on a recapitalization.

With Rogers Sugar being my other major equity holding, they are due to announce what they plan on doing with their corporate structure. As it is likely they will be contemplating the same thing, investors would be wise to look at trusts that are planning conversions and seeing if they can realize short term trading opportunities. I know that in 2011 the structure of my registered accounts will be looking different since I want to move dividend-bearing securities outside the RRSP because dividend income will be virtually tax-free.