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.