Source: Travis Johnson, Stock Gumshoe-website
February Idea of the Month: Buying a Manager Whose Performance We Love
Posted on February 15, 2013 by Travis Johnson, Stock Gumshoe
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I broke up today’s piece into several different articles because there have been quite a few things going on this week with companies I follow or am interested in, so this “Idea of the Month” piece profiling one of our watchlist stocks will not (I hope) be overly long. The other piece I shared today are these if you want to catch up with those:
Sandstorm Steps Away from Political Stability, Gets Punished
Africa Oil — Results Look Great, Market Underwhelmed
Iron Falls off a Cliff — What does that mean for Altius?
And now, on to our Idea for this month — MFC Industrial.
When you buy shares of MFC Industrial (MIL), you’re really buying into the long-term performance and contrarian asset-management CEO Michael Smith, who has compounded earnings for investors at something like 15% a year for well over a decade through a confusing array of investments, splits, company changes and contrarian investments. I haven’t bought shares myself personally just yet, but I put it on the watchlist last month, and this month I want to recommend that you take a look and consider it for yourself after we’ve dug into the business a little bit.
MFC Industrial is the result of a long history of financial engineering — takeovers, mergers, spinoffs, etc. — and it is not a company that is likely to provide rapid outperformance over the next few months, but I think it has great potential for continuing to create real shareholder value over the next several years as they roll up an inefficient and undercapitalized industry and take advantage of some very undervalued assets.
You might know MFC Industrial under the prior names Terra Nova Royalty and KHD Humboldt Wedag — the latter, in particular, was often a stock that popped up on investor screens for cash-rich companies because it traded at less than the value of its net cash on the books. KHD spun off its cement plant business and renamed itself Terra Nova Royalty, based largely on their royalties on the Wabush Iron Ore mine, and has more recently been re-engineering itself, under the new name MFC Industrial, as an industrial commodity supplier and trader. Not a sexy business, but quite a profitable one and ripe, it appears, for consolidation.
The reason MFC Industrial came to mind is that they made a big, contrarian deal in natural gas last Summer that has dramatically boosted their book value (like many value-focused managers, Smith focuses on growing book value or “asset value” per share more than on quarterly earnings) — it so happens that this deal, in which they acquired struggling Compton Petroleum in September, also resulted in a huge paper profit that makes it look like MIL has a ridiculously low PE of about 3. That’s not cash earnings, that’s just a writeup of their acquisition cost, but it serves to amplify the magnitude of the discount Smith got on that deal … and how profitable it might be for MIL in the future.
Even after the deal closed, with the writeup of negative goodwill that boosted earnings and book value, MIL is still trading at a 20% discount to book value. We’re looking at this as a way to compound income over several years as MFC Industrial adds value to its substantial assets, including the underutilized Compton Petroleum processing assets, but we also get paid along the way — the company policy is to pay a dividend that is 25 basis points higher than the trailing dividend of the NYSE Composite (declared annually — so for 2013 the dividend is 24 cents per share, payable at six cents per quarter, which means a current yield of about 2.4% at the recent $10 share price). I put the shares on the watchlist because I wanted to take some more time to look at the big change to book value from that Compton deal, and I was hoping the shares would come back down in price — but they’re proving pretty resilient at this new and increased valuation, with the charts and momentum also on its side (not that I put a lot of weight on that) … so I think it’s a good time to take a first nibble, and hopefully we’ll see some dips for future buying opportunities.
First let’s get a quick overview of MFC Industrial and how they make money. Here’s how they describe themselves:
“MFC Industrial Ltd. is a global commodity supply chain company that sources and delivers commodities and materials to clients all over the world, with a special expertise on the financing and risk management aspect of the business. The team at MFC Industrial Ltd is able to locate and procure basic materials and commodities for clients around the world, and brings a knowledge of logistics to the table that includes all major modes of transport, government relations and regulatory environments.
“The Company has experience with ores, metals, energy, plastics and lumber, and can source and deliver these and other commodities efficiently and timely.
“MFC Industrial Ltd. commits its own capital and personnel to capitalize on its sourcing, finance, risk management and logistics capabilities and experience to maximize returns throughout the commodities supply chain. Commodities either originate from the company’s own production assets or are sourced from third parties.”
So we can think of them as sort of a junior version of Glencore, commodity supplier and trading house that also trades on their own account and produces some of their own commodities and takes some of the commodity price risk (and profit). They are now particularly exposed to iron ore and to natural gas, but as active merchants of these and other commodities they also hedge away some of their commodity price exposure. Beyond that supply chain and commodity work, they are also active in merchant bank financing — largely to finance deals for their commodities customers, which means they can provide better service as they wrap up financing along with the sale.
MIL has a lot of irons in the fire, some long-term and some almost immediate — their have some reasonably consistent cash generation from the royalties they have on one of Cliffs’ iron ore mines (Wabush, in Labrador) that has had some production trouble with their concentrator but still produces enough ore to generate roughly $25 million a year for the royalty to MIL lately. This is a declining mine, with production lower, so they’ve had a nice boost recently with relatively high iron ore prices but it won’t likely be a big, growing asset. The royalty persists until 2055, but from what I can tell the mine is unlikely to live that long.
They also have two other iron assets — they are 50% partners in the historic Pea Ridge mine in Missouri and they’ve been studying the potential of the mine with an eye to re-opening it at some point. They’ve done drilling to confirm some resource estimates, but they don’t seem to be in a particular rush — the mine would have to be dewatered, and they have delayed the dewatering while they conduct other studies and assessments, so that indicates to me that this isn’t a top priority to throw money at for Smith.
And they also have leases and purchase agreements with iron ore producers in Goa, India — an area where major scandals have led to the squashing of the iron ore industry, at least so far. MIL is still saying, optimistically, that this is an “emerging market problem” and that they expect the mining in Goa to resume at some point soon, but the Courts in India have kept the mines closed. Goa’s economy is very mining dependent and there is pressure to reopen the mines, but I have no idea when or if that will happen — MFC says they do not have any obligations or debt connected to their Indian assets, but obviously they aren’t earning cash from those operations now.
But the more interesting stuff, aside from MFC’s continuing work to consolidate the supply chain for commodities in North America through acquisitions, is in the Compton Petroleum deal — a deal which cost them little cash, has resulted in several sale-able assets and the addition of valuable processing plants and pipelines in Western Canada that they think they can use to generate more cash, and gives them good leverage to natural gas that is now sitting in the ground, with little in the way of carrying costs. And it just might also provide up to $500 million in tax benefit pools, too, though it seems like MFC is being cautious in what they say about those tax loss assets (Michael Smith has used tax losses to offset earnings a lot in the past, including with the Wabush royalty that rolls through some other entities that had big tax losses to absorb the taxable earnings, and the company has paid very little in taxes in recent years).
The transformative deal to buy the (very) troubled Compton Petroleum means that MFC Industrial quite rapidly gets a position in the energy supply chain — particularly natural gas and the more valuable natural gas liquids (NGLs), but also a little bit of oil. They essentially swooped in when natural gas prices were cratering last Spring and Summer and Compton was having trouble with credit lines getting cut by lenders and bought up the company for $33 million plus Compton’s sizable debt (MIL is in much better shape to handle the debt — they used some of their cash to write it down and improve the terms, and also have enough net cash that the new debt doesn’t endanger their balance sheet). Because Compton had a book value of a few hundred million dollars, MIL had to report that excess book value as negative goodwill (usually you hear the reverse — companies pay more than the carrying value of an acquisition and therefore have to add goodwill to the balance sheet … but negative goodwill, buying something that’s worth more than you paid for it, has to be reported as income). That book value was inflated with natural gas at $2.50, perhaps, but it is likely worth a bit more now with natural gas rebounding a bit — and the large land bank with more than 500 drilling locations available and the 900+ active gas wells (and a few dozen oil wells) have substantial value as long as gas prices don’t collapse.
So now the company has assets of over a billion dollars, net debt that’s quite manageable, and a book value per share of $12.79. The current price is roughly a 20% discount to book value, which has been a typical discount for MIL in recent years (it dipped below that for a few weeks late in 2012 and early in January, but I missed those dips). I think buying an initial position at around this price (below $10.50 or so) is reasonable, and we’ll wait to see what we learn about the actual operations of the combined company in the fourth quarter when they report those numbers in late March.
Right now, it looks like the run rate for earnings for the first three quarters of the year (ignoring the one-time gains from the acquisition write-up of goodwill) would be roughly 60 cents per share — they may not hit that for the year, particularly given the delays at the Wabush mine and the shut-in in Goa, but that’s roughly what they were hitting as of the first thee quarters. If they maintain that level of earnings, that’s a trailing PE of about 16.
The company doesn’t often move based on the earnings, they tend to move on reported deals and changes in book value, but I wouldn’t want to pay more than that until we learn about what kinds of divestments they’re able to make of the Compton Petroleum assets that they don’t want to keep — indications from some analysts early on were that they might be able to recoup a substantial portion of the acquisition cost just by selling off non-core gas or processing assets or land, but the company tends to be quiet about operations between earnings releases. If natural gas continues to recover a bit and stabilizes in the $4+ neighborhood, I think this Compton deal might turn out to have been an incredible steal, one in a long series for Michael Smith. At the current valuation it doesn’t have to be a steel, and we don’t have to see significant improvement from Wabush or a restart of Goa mining … but if those things happen, earnings could jump up considerably and book value could continue to grow nicely for an extended period of time.
The latest quarterly release from MIL is here, the Investor Presentation is here, and if you want to dig into the history of Michael Smith’s machinations (not all of which have been beloved by shareholders) there’s a good SeekingAlpha piece here that’s quite old but does a solid overview.