Cervus Equipment buyout – takeover price undervalued

It has been an exciting 2021 with my third company getting receiving a takeover solicitation. Cervus Equipment (TSX: CERV) announced it was being acquired by Brandt Tractor for CAD$19.50/share in cash.

This is still a dirt cheap valuation.

Not surprisingly, they want to close the deal pretty quickly:

Cervus expects to hold the Special Meeting of shareholders to consider the Transaction in October 2021 and to mail the management information circular for the Special Meeting in September 2021. Subject to the conditions set forth above, the Transaction is expected to close in the fourth quarter of 2021.

A two-thirds vote is required, with the chair holding 18% of the stock, coupled with Brandt holding another 9%. Unless if there is some organized opposition to this deal, it looks like it is going to proceed.

The price that is being paid is cheap. CERV has 15.4 million shares outstanding and from the first half alone has generated about $1/share in earnings. Cash-wise, in the first half they have generated about $23 million (about $1.5/share) in free cash. Full-year, they’re probably going to pull in something around $2.50-$3.00/share. Balance sheet-wise, they are at around $40 million net cash, and approximately $13/share in tangible book value, or $16.85 if you include the intangibles and goodwill. Brandt is paying a slight premium over the balance sheet value, but given the earnings power of the company, they are getting a very good price. It is too good a price.

A fair deal would be around $23-24 in my estimation, but who am I to say?

There is some precedent for a small boost up in price – Rocky Mountain Equipment (formerly TSX: RME) was taken over in the middle of the Covid crisis last year for what could be considered a total steal of a price. The original all-cash $7.00 management takeover was boosted to an all-cash $7.41.

In a final slap in the face, the following:

Pursuant to the Arrangement Agreement, the Company has agreed not to declare or pay any common share dividends until the completion or termination of the Transaction.

That said, overall, if the deal goes through at the $19.50 price, I would have made around a 150% gain on this over a year. It was a small position (obviously should have been larger, but the liquidity was awful and there was other stuff on my radar at the time), but just like most good trades, you always wish you took more of it.

I’ll be voting against the deal if I still have my shares. The price of $19.29 presently is a 21 cent merger arbitrage on an October closing and at 6.5% annualized, I’ll hold and hope that there is a minor increase in the takeover price. Other than the Chairman, the greater than 5% owners holding this, at least according to TIKR, are Invesco Canada (7.3%), Burgundy Asset Management (7.2%), Fidelity (6.6%) and Van Berkom (5.8%). They will have to get together to extract another few dollars out of this thing before it delists.

Unlike Atlantic Power and its convoluted capital structure, I have no fears that this deal won’t be closing. At worst, it’ll be cashed out at $19.50/share in October and the capital will go to another happy home.

Ag Growth – Ag Shrink!

Ag Growth (TSX: AFN) used to be my largest portfolio component, but by virtue of depreciation and something else in the top 5 that has appreciated, is no longer. The company’s stock has taken a beating over the past 3 months:

The market was spooked by their Q1 (May 2021) announcement on their conference call regarding the pricing of steel (indeed, when looking at Stelco (TSX: STLC) you can see what they mean) – companies quote projects and their quotations typically remain open for 30 days, but this is like giving your customers a free one month call option on steel pricing, so they had to tighten this up. They said the high-cost backlog would cost them some margin in Q2 and Q3 but it would normalize in Q4 onwards.

In Q2, there was some margin degradation, and besides this, the quarter was reasonably decent. Sales up, gross profits up, margins slightly lower but this was to be expected. However, the killer payload was this line:

In 2021, two legal claims related to the bin collapse were initiated against the Company for a cumulative amount in excess of $190 million, one of which was received subsequent to the quarter ended June 30, 2021. The investigation into the cause of and responsibility for the collapse remains ongoing. The Company is in the process of assessing these claims and has a number of legal and contractual defenses to each claim. No further provisions have been recorded for these claims. The Company will fully and vigorously defend itself. In addition, the Company continues to believe that any financial impact will be partially offset by insurance coverage. AGI is working with insurance providers and external advisors to determine the extent of this cost offset. Insurance recoveries, if any, will be recorded when received.

I had a massive due diligence failure, especially considering one of these two events was within a car ride of where I am. Fibreco sued Ag Growth International and also the professional engineer that signed off on it, in BC Supreme Court on June 4, 2021. There was also a news article on the matter which I totally missed.

This is probably the biggest contributor to the stock getting tanked over the past quarter. $190 million is close to $10/share, but the larger impact is the balance sheet threat.

Ag Growth relies a lot on low cost debt capital to fund its operations. Given the nature of its business, their cash flows are relatively predictable and there is a seasonality with cash collections that require the usage of credit. Their debt structure is funded by unsecured debentures (AFN.DB.D, E, F, G and H) each of which is around $86 million in quantity. The unsecured debt is termed out, with D and E maturing in June and December 2022, while the rest of them are out in 2024 and 2026. They also have some tranches of first-in-line bank debt as follows:

Note that they all term out in 2025 and there is about $95 million of availability on the Canadian revolver and $29 million on the CDN swing line.

However, all-in-all, given there is a total of $900 million of debt between these two series ($430 million of unsecured, and $470 million of secured, roughly at an average weighted cost of around 3.9%), the company’s leverage position is quite extended. Tacking on another $190 million on top of that is a tall order. An increase in the cost of capital, needless to say, will be adverse for the equity holders (a 1% increase in capital cost is about 50 cents per share, pre-tax).

The risk has definitely increased due to the number of unanswered questions.

1. How much will insurance actually cover, especially in the event that AFN is found to be at-fault? What is the maximum coverage? (God forbid if the majority of it was self-insured).
2. When will these proceedings resolve themselves (typically it will be by settlement, but a trial would take a couple years to clear out undoubtedly)
3. (by far, the biggest factor of these three, in my opinion) Because AFN screwed up (whether it is their fault or not, doesn’t really matter at this point) building two grain towers, are there any other towers of like composition that are waiting to crumble down?
4. Will re-financing risk be a factor (specifically with AFN.DB.D, and E)?

Question number 3 could literally be a case of waiting for another time bomb to go off, in the form of another grain silo collapse. Another such event would tank the equity by 20% in a day. This is a sort of unknown-frequency, high severity event that elevates risk.

On the flip side, we have the following:

1. The market for AFN’s unsecured debt is still strong (trading just slightly above par at the moment across the entire term) although the whole point of doing this market analysis is to determine when the market is wrong! That said, if there is some debt distress, it isn’t being reflected in these prices;
2. The company, at least on a basis when grain towers aren’t imploding, should be able to generate around $45 million in cash this calendar year, and in a more normalized year, should be able to generate north of $100 million and de-leverage. This is…
3. … fueled by the fact that agricultural products have had their supply chains really disrupted and the demand for product should create demand for capital spending on agricultural equipment.
4. Lawsuits, especially in Canada, very frequently settle for below the “face value” on the claim.

My last comment is that there was some premium valuation in AFN on the basis of “Ag Tech”, but it appears that this bubble has popped with Farmer’s Edge (TSX: FDGE) cratering (it’s down 75% since its IPO and indeed closer to where it should be trading!). This part is healthy.

The current dividend, at 60 cents per share, or $11 million a year, is not particularly onerous to maintain, especially in the case of ‘normal’ business performance, which should be a lot higher than what they have been doing in the past.

If the overhang on the stock is purely on the basis of this lawsuit, the stock is at a price level where it is attractive. If there are more structural issues with the industry that AFN is in, then my original investment thesis was flawed. I do not believe this to be the case, but definitely the elevation of risk is reflected in the stock price. I’m not happy with this situation, nor am I happy about how it was presented in the past few quarters.

The last chapter on Gran Colombia Gold’s senior secured notes

Quoting the press release:

Gran Colombia Gold Corp. (TSX: GCM) announced today that it has successfully priced an oversubscribed offering of US$300 million in senior unsecured notes due 2026 at a coupon rate of 6.875% (the “2026 Notes”) pursuant to Rule 144A and Regulation S of the U.S. Securities Act of 1933, as amended, (the “Act”), with closing expected to occur on or about August 9, 2021.

The proceeds from the 2026 Notes will be used to: (i) to fund the development of our Guyana operations, (ii) to prepay the remaining Gold-Linked Notes, and (iii) for general corporate purposes. The 2026 Notes have been assigned a rating of B+ by Fitch Ratings and a rating of B+ by S&P Global Ratings.

That’s a lot of money they raised, and in unsecured form! It’s quite the turnaround from years ago when they had to struggle to raise capital through the gold-linked notes (TSX: GCM.NT.U).

It looks like the remaining US$18 million of notes will finally get called out at 104.13. GCM has to provide 30 days of notice of redemption and this will likely happen once the deal closes.

(Update, August 9, 2021: This redemption notice occurred, slated for September 9, 2021).

Robinhood IPO

The true top in the dot-com bubble had to have been the public offering of Palm in the year 2000. Does anybody remember that?

Likewise, Robinhood’s IPO portends to be the equivalent for retail investors gamblers. These sorts of things can only be determined in retrospect, so such statements are not predictive.

That said, Robinhood’s metrics are actually pretty good!

As of March 31, 2021, they have $81 billion in assets under custody and 17.7 million active users. After the IPO they will have 842 million shares outstanding, for a market cap of about $30 billion.

What do we compare this with? Interactive Brokers is a logical counterpart – both companies have functional controlling shareholders, so public investors are simply there for the ride.

IBKR’s public offering is about 22% of the “real” company, but I’ll put a lot of technical stuff aside and state their total market cap is $26 billion on 417 million shares.

This is very similar to Robinhood.

IBKR also provides very good data to the public. More so than Robinhood. For example, Robinhood does not disclose how many trades it executes, while IBKR does.

At Q1-2021, IBKR executed 306 million trades. They have 1.3 million customer accounts and total customer equity of $331 billion. Almost ten times less customers, but four times more customer equity.

In terms of the balance sheet, IBKR has a book value of $9.4 billion, and HOOD post-IPO is around $7.3 billion.

HOOD, however, is growing like a weed. Their Q2 estimate is 21.3 million active users and $102 billion in assets under custody.

The big difference is that HOOD isn’t making that much money (most of their revenues are being sucked up by operating costs), while IBKR is making a ton of money.

But given the amount of capital people are willing to dump into the Robinhood brokerage, coupled with encouraging them to gamble and/or pitch them financial products, makes me think that their valuation isn’t ridiculously stupid. It’s in the ballpark of where it should be.

Despite loving the IBKR platform (it truly is the best, once you use it, you can’t go back), I would not be an IBKR investor at this valuation, nor am I interested in HOOD stock.

My primary concern for HOOD investors is not the valuation. It is that their technology has some sort of problem where they end up like Knight Capital and simply blow themselves up. It’s a much more relevant possibility for them (simply because they are so new) compared to very seasoned brokers like IBKR that have been at it for decades.

Featured on the Globe and Mail – reflections on dealing with short selling reports

I’d like to thank Larry MacDonald for mentioning me on his regular article on the Globe and Mail about short selling on the TSX.

A hedge-fund analyst once sold short a company in which Sacha Peter had invested. Then he published a critique on it.

Did Mr. Peter, author of the Divestor blog, rush to his keyboard to click on the sell button, or log into online forums to urge a squeeze on the short seller? Not at all.

Instead, he rolled up his sleeves and dived into the critique. After reading it, the shares remained in his portfolio and were later unloaded at a profit.

It may not always turn out as well as it did for Mr. Peter, but there is something to be said for monitoring the trades of short sellers to see if any are targeting a stock you hold. As Mr. Peter says, “I very much like reading the short-sale cases of anything I hold. It forces me to check my analysis.”

Larry was referencing my post back in April 2018, The case to short Genworth MI, where a very intelligent young analyst won an accolade for writing a fairly comprehensive short report on Genworth MI.

Keep in mind there is no “one size fits all” strategy concerning how one deals with new information that comes with people or institutions issuing short selling reports on your holdings. Everything depends on your ability to perceive fact from fiction, and perhaps more maddeningly, perceive the market’s sense of reality versus fiction that they bake into the stock price.

I’ll also talk about a time where I got things less correct.

Go read my August 2020 post on what happened when a short selling firm released a report on GFL Environmental. I had taken a small position on one of their hybrid securities (effectively yield-bearing preferred equity with equity price exposure above and below a certain GFL price range) and then a short sale report came out. I bailed very quickly. Retrospect has shown that wasn’t a good decision financially (right now GFLU is about 70% above what I sold it for including dividends), but one of the reasons for bailing was because I was not nearly as comfortable with my level of knowledge about the company than I was about Genworth MI. Another reason is that there were still very active market reverberations going on during COVID-19 so there were plenty of alternate investment candidates for my capital. I’d also like to give a hat tip to Jason Senensky of Chapter 12 Capital for his comment that has stuck in my mind ever since, which is his insightful analysis that my “return on brain damage is too low” – which indeed is an accurate reflection that my mental bandwidth on such cases is better spent elsewhere.

And while I’m on this topic, Jason also wrote a fantastic article on the near-demise of Home Capital Group, instigated by a high profile short seller. Hindsight is 20/20, but I feel like there was a missed opportunity on that one – I should have taken the cue after they announced they obtained their ultra-expensive secured line of credit facility (it marked the bottom of their share price).