Surveying the Net Net Landscape

This morning, right after I brushed my teeth, I went to my trusty Bloomberg terminal and punched out “Bloomberg, Bloomberg, computer on my desk, who’s the fairest of them all?” (10 points* if you knew that was an Other People’s Money reference).

What Bloomberg brought back to me was the following list of of net current asset value stocks. Criteria:

• Stocks Trading on North American Exchanges
• Domiciled in either Canada or the United States
• Market Cap greater than $5 million
• Market Cap is 120% or less of NCAV
• Net Current Asset Value = (Cash & Marketable Securities + Accounts Receivable + Inventory – Total Liabilities – Preferred Equity – Minority Interests).

Please note, I have done no due diligence to check or verify this data. Financial data may be out of date, there may be multiple share classes, or (and I don’t mean to alarm you) there may be a bogeyman or bogeymen in the details. In other words, do your own research.

A few interesting facts:

• According to Bloomberg, there are 62 companies in the U.S. and Canada trading below NCAV (with market caps >$5 million).
• Of the 95 stocks in the table (trading at or below 120% of NCAV):
• 49 are Canadian (51.6%) and 46 are U.S. (48.4%)
• 32 (33.7%) are in the Materials sector, with the vast majority of those in the mining/gold/silver sub industries.
• The average market cap of the group as a whole is $28.5 million, with the largest company being Buhler Industries at $156 million.

And now, with no further delay, the table. Happy hunting!

NCAV Securities as of June 18, 2014

Ticker	Name	Country	NCAV	Market Cap	Market Cap / NCAV
UNRH	UNR HOLDINGS INC	US	$83,759,418	$19,571,840	23%
KGHI	KAISER GROUP HLD	US	$16,639,000	$5,084,752	31%
CLWA	CALLWAVE INC	US	$32,406,000	$10,388,392	32%
AAB	ABERDEEN INTL IN	CN	$37,660,350	$12,665,666	34%
HERB	YASHENG GROUP	US	$382,362,961	$130,902,168	34%
LKII	LAZARE KAPLAN	US	$44,982,000	$16,422,831	37%
ALSC	ALLIANCE SEMICON	US	$71,248,000	$28,090,700	39%
SRTI	SUNRISE TELECOM	US	$11,273,000	$5,134,906	46%
KZX	KAZAX MINERALS I	CN	$19,020,073	$8,722,319	46%
SPCO	STEPHAN COMPANY	US	$12,328,000	$5,953,745	48%
TAIT	TAITRON COMPONEN	US	$11,043,000	$5,373,564	49%
BXLC	BEXIL CORP	US	$36,822,806	$18,555,432	50%
UPGI	UNIVERSAL POWER	US	$16,280,000	$8,283,000	51%
BAT	BATERO GOLD CORP	CN	$16,128,889	$8,796,129	55%
LN	LONCOR RESOURCES	CN	$9,300,400	$5,140,781	55%
TSPT	TRANSCEPT PHARMA	US	$67,885,000	$39,218,728	58%
ARL	AFRICO RESOURCES	CN	$55,532,501	$33,873,736	61%
PDQ	PETRODORADO ENER	CN	$27,086,067	$16,889,148	62%
SPGZ	SPECTRUM GROUP	US	$27,793,000	$17,652,448	64%
TWMC	TRANS WORLD ENTM	US	$163,232,008	$103,897,384	64%
SVU	SPUR VENTURES	CN	$29,187,887	$18,726,228	64%
NUX	NEW PACIFIC META	CN	$25,483,641	$17,069,248	67%
DNV	DUNAV RESOURCES	CN	$11,670,345	$7,889,375	68%
NRE	NAMIBIA RARE EAR	CN	$13,155,038	$8,950,278	68%
MUN	MUNDORO CAPITAL	CN	$13,073,487	$9,121,723	70%
INV	INV METALS INC	CN	$21,052,514	$14,826,293	70%
KRN	KARNALYTE RESOUR	CN	$49,040,879	$34,623,552	71%
TSRI	TSR INC	US	$8,410,689	$5,945,048	71%
ORG	ORCA GOLD INC	CN	$85,898,869	$61,221,280	71%
KXM	KOBEX MINERALS I	CN	$34,138,818	$25,140,932	74%
RYG	RYAN GOLD CORP	CN	$20,338,569	$15,228,192	75%
AMR	AMAROK ENERGY IN	CN	$21,647,702	$16,312,676	75%
IDEA	INVENT VENTURES	US	$9,158,679	$7,053,286	77%
MWC	MEDWELL CAPITAL	CN	$12,230,000	$9,467,366	77%
MSN	EMERSON RADIO	US	$61,967,000	$48,019,804	77%
OEG	ONENERGY INC	CN	$15,885,000	$12,556,398	79%
RDU	RADIUS GOLD INC	CN	$13,613,703	$10,834,452	80%
STC	SANGOMA TECH COR	CN	$10,275,470	$8,216,496	80%
PRLS	PEERLESS SYSTEMS	US	$11,873,000	$9,523,083	80%
IGOI	IGO INC	US	$11,385,000	$9,275,827	81%
SODI	SOLITRON DEVICES	US	$10,973,000	$9,071,203	83%
JLMC	JLM COUTURE INC	US	$6,909,564	$5,718,955	83%
SPRS	SURGE COMPONENTS	US	$8,757,133	$7,257,071	83%
PTNT	INTERNET PATENTS	US	$29,299,000	$24,418,648	83%
CRV	COAST DISTR SYS	US	$20,442,000	$17,094,982	84%
ECC	ETHOS GOLD CORP	CN	$8,731,667	$7,388,015	85%
SWD	SUNWARD RESOURCE	CN	$29,261,302	$24,907,284	85%
MBS	MOBIUS RESOURCES	CN	$14,834,000	$12,673,688	85%
RELL	RICHARDSON ELEC	US	$159,301,000	$140,253,328	88%
TCCO	TECHNICAL COMM	US	$9,502,425	$8,514,204	90%
IDC	INTL DATACASTING	CN	$6,397,125	$5,850,629	91%
STLY	STANLEY FURNITUR	US	$43,303,000	$39,635,320	92%
ZC	ZIMTU CAPITAL	CN	$7,307,772	$6,759,292	92%
COSN	COSINE COMMUNIC	US	$19,938,000	$18,865,714	95%
CRG	CORONA GOLD CORP	CN	$10,124,632	$9,635,355	95%
ADI	ADRIANA RESOURCE	CN	$28,886,625	$27,571,992	95%
SN	SENNEN POTASH CO	CN	$8,041,069	$7,780,039	97%
MSV	MINCO SILVER COR	CN	$60,367,081	$58,415,924	97%
UGD	UNIGOLD INC	CN	$7,489,165	$7,311,397	98%
CNDO	CORONADO BIOSCIE	US	$80,217,000	$78,863,000	98%
GENC	GENCOR INDS INC	US	$104,459,000	$103,743,824	99%
ELR	EASTERN PLATINUM	CN	$93,425,000	$92,818,784	99%
PARF	PARADISE INC	US	$15,594,532	$15,691,920	101%
CDCO	COMDISCO HOLDING	US	$19,952,000	$20,144,756	101%
VII	VICON INDUSTRIES	US	$11,556,038	$11,710,101	101%
DCTH	DELCATH SYSTEMS	US	$25,620,000	$26,158,662	102%
BSHI	BOSS HOLDINGS	US	$23,260,000	$23,895,528	103%
GIC	GENTERRA CAPITAL	CN	$13,798,496	$14,217,792	103%
EPL	EAGLE PLAINS RES	CN	$6,485,414	$6,699,094	103%
SDOI	SPECIAL DIVERSIF	US	$23,578,000	$24,392,062	103%
ORBT	ORBIT INTL CORP	US	$12,832,000	$13,341,849	104%
GRG	GOLDEN ARROW RES	CN	$8,634,103	$8,981,204	104%
BEV/H	BENEV CAPITAL IN	CN	$67,968,188	$71,740,960	106%
AEY	ADDVANTAGE TECH	US	$28,510,396	$30,453,292	107%
BLT	BRILLIANT RESOUR	CN	$10,491,009	$11,209,108	107%
SMGI	SMG INDIUM RESOU	US	$17,597,740	$18,836,394	107%
HCI	HARTCO INC	CN	$38,901,000	$41,649,628	107%
LVN	LEVON RESOURCES	CN	$46,520,825	$50,013,604	108%
HMM/A	HAMMOND MANUF-A	CN	$15,236,000	$16,434,734	108%
FRD	FRIEDMAN INDTRY	US	$50,786,076	$55,484,144	109%
AXTI	AXT INC	US	$61,276,000	$68,470,408	112%
BUI	BUHLER INDS	CN	$139,210,992	$156,000,000	112%
PCO	PHOENIX CAN OIL	CN	$7,087,715	$7,970,527	112%
DL	DANIER LEATHER	CN	$32,380,000	$36,421,888	112%
MLR	MELIOR RESOURCES	CN	$21,574,998	$24,318,928	113%
SMIT	SCHMITT INDS	US	$7,391,043	$8,374,548	113%
GDL	GOODFELLOW INC	CN	$73,631,000	$83,789,560	114%
ATX	ARGENTEX MINING	CN	$5,241,142	$5,970,570	114%
TRGT	TARGACEPT INC	US	$122,479,000	$140,206,048	114%
OPST	OPT-SCIENCES	US	$11,939,854	$13,689,075	115%
FOS	PHOSCAN CHEMICAL	CN	$41,946,905	$48,596,944	116%
HYD	HYDUKE ENERGY SE	CN	$14,597,455	$17,028,384	117%
BVSN	BROADVISION INC	US	$40,715,000	$47,950,592	118%
SUP	NORTHERN SUPERIO	CN	$6,320,701	$7,546,196	119%
SVT	SERVOTRONICS INC	US	$14,418,000	$17,286,616	120%

Full Disclosure:  Author may hold a position in securities listed in the table.

*Points have no cash value, are redeemable for nothing, and in every sense of the word are “pointless.” Now puns on the other hand . . .

Harvest Investor © 2014. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Unsolicited Advice for Community Bankers

From time to time I like to pitch a business idea that appeals to me since . . . well, it’s my blog and I can.

One area that I've been thinking about recently is community banking. I've come to the conclusion that many local banks (some much smaller than you’d think) could benefit greatly by expanding into the money management business.

Many of the larger banks (regional, super-regional, money center) have long capitalized on cross-selling services and using investment products to boost fee income (look at a bank like BB&T which boasts a fee income ratio near 44%). Yet, when you look at the smaller, more community based banks, they are lacking in this area. I contend that this is a major misstep for those institutions.

Historically, many community banks allowed 3rd party brokers (such as Investment Centers of America, Inc.) to place offices in their branches. In exchange, the bank received a revenue sharing agreement and the ability to tell customers it had a broker in the bank. Unfortunately, due to the inherent conflicts of interest (not a bank employee, not a customer fiduciary, paid on account turnover, 12b1 fees, etc.), this was equivalent to a doctor telling his patients “great news, I’m now sharing offices with a mortician.” (OK, bad analogy, but I’m going with it nonetheless). Like most 3rd party fixes, it left customers confused and alienated when problems arose.

A better fix, in my opinion, would be for a bank (bank holding company technically) to create an SEC Registered Investment Advisor (RIA). This model, although embraced by some of the larger regional banks (often paired with a trust department) is more downward scalable than most community bankers realize. The benefits for community banks are numerous:

• It’s a low capital intensity / overhead business (high margins). Start up costs are minimal (the registration process is cumbersome, but not expensive) and ongoing overhead (employee costs, compliance) are manageable.
• RIAs are fiduciaries for their clients. They charge fees based on account size, not asset turnover. As such, they are (in theory) incentivized to do as well as possible for clients (higher account size = higher fee).
• For family owned community banks, an RIA subsidiary can basically function as a quasi-family office. Instead of the controlling family having to find an outside money manager, why not have your own in-house RIA that can manage family funds, bank holding company excess capital, the bank’s bond portfolio (more on that below), and portfolios for bank customers.
• By funding the RIA with “seed capital” from the banks owners, the investment advisor immediately starts with an asset base (don’t have their backs against the wall), and it creates a nice selling point to potential customers: “the owners of the bank invest their funds with us, you should too".
• Many banks have to hire outside investment consultants to administer their 401k plans. With an RIA sister company, this service can be internalized (leading to cost savings) and a nice cross-sell opportunity (by doing 401k education with bank employees, the RIA is also educating on the services they can provide to external customers).
• There can be overlap / efficiencies between the banks bond portfolio and investment customer accounts. Too many community banks outsource their bond buying to 1 or 2 brokers (i.e. “I bought a new bond – Vining Sparks said it was cheap”). Having a full time investment professional searching for bonds for the bank as well as investment customers can create a nice cost savings / efficiency gain. 
• Having the bankers and portfolio managers be on the same team (owned by the same company) alleviates (some) conflicts of interest – both are paid from the same pool, so if a client is more comfortable in bank CDs, the RIA sends them there (and vice versa). There is no (or minimal) fighting over customers.
• With the low overhead structure, the RIA business could probably be break even with $10 - $15 million AUM (depending on employee compensation structure, fee schedule, etc.).

Bottomline, for the cost of 1-2 employees (with one of those employees possibly being an already underutilized staffer), a bank can create a new fee income source, create internal cost savings (bond portfolio, 401K management), build brand awareness (new services for customers, all under one roof), and have its own “family office,” all with very little cost/overhead.

I remain confused as to why more banks haven’t taken this route (although am in no way so confident that I don't think there must be a good reason). Obvious reasons in my mind would be:

• A lack of qualified employees / candidates to run the RIA.
• The philosophy (which I usually agree with) that a bank should stick to what it knows best – lending and deposit gathering.

However, as the regulatory environment becomes more restrictive (higher capital requirements), compliance costs skyrocket, and bigger banks continue to pressure community banks on loan rates, a little fee income diversification might not be a bad thing, right? As usual, this is just my off the cuff thoughts on the business. I’d be glad to hear the thoughts of others, especially those in the community banking world.



Harvest Investor © 2014. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

PhosCan Chemical: Slow Burn, No Return

There’s something about a net cash stock that gets me excited. I guess it goes back to the old value concept of being offered $1.00 worth of something for $0.50 (or, as you’ll see below, $0.8146). With that in mind, I submit to you PhosCan Chemical Corp. (FOS on the Toronto Stock Exchange, or PCCLF on the U.S. OTC market).

FOS is a Canadian company with only two real assets:

• ~C$57million in cash and short-term investments.
• 100% ownership of a mining claim (called the Martison Phosphate Project) which covers over 20,000 acres northeast of Hearst, Ontario.

The Cash
If we look at FOS as a cash box, netting the cash and short-term investments against total liabilities*, we get net cash per share of C$0.356 as of 10/31/13 (most recently reported financials). Shares closed today at an ask price of C$0.29.

*I am assuming that the ~C$16 million deferred tax liability will never be payable, and will be wiped out by writing off a portion of the mine development costs.



With most “development” stage companies, they burn through cash in the process of research & development, making what appears to be a net cash stock nothing but an illusion. As the above chart shows, FOS has bucked this trend, managing to hold net cash roughly steady over the past two years by offsetting operating costs with (1) interest earned on the investment portfolio and (2) buying back shares (i.e. management is buying $1.00 for $0.80555). A company trading at a 23% discount to net cash and a slow to nonexistent burn rate on that cash is what piqued my interest in FOS.

The Mine
FOS other key asset is the Martison Phosphate mine (as of yet undeveloped) in Ontario. The potential mine is currently valued on the balance sheet at just shy of C$94 million (C$1.5 million for the land, C$92.4 in development costs). That’s right, over the last 30 some years, investors/speculators have poured nearly C$100 million into trying to find and develop a phosphate rock mine (with more recent rumblings about the nioubium potential of the property) on this claim. As of yet, they have nothing ($) to show for it (but Columbus had nothing to show for years of work and preparation the day before he spotted the “New” world, right?).

I’ll be honest – I have very little knowledge of the mine. There are some good arguments for why the mine has value: 

• Expected high grade phosphate deposit at 23.55% phosphate and an indicated resource of 62.2 million tons. 
• Agrium (AGU) is winding down a nearby phosphate mine in Kapuskasing, leaving a gap in local/Canadian phosphate production. 

However, there are good arguments for why the mine has little value: 

• Agrium has already sourced replacement phosphate production from Morocco. 
• Global phosphate reserves are not in short supply (304 years at estimated 2012 worldwide production capacity [assumes 100% capacity utilization] according to 2013 USGS data book).
• The price of phosphate rock is not encouraging to new mine development:

Source: http://www.indexmundi.com/commodities/?commodity=rock-phosphate&months=120

The Conclusion
What I find more instructive than what FOS is doing with its cash (buying back shares in a shareholder friendly manner) is what they aren’t doing. They aren’t returning what is, almost inarguably, an overcapitalized balance sheet to shareholders (observe what Selwyn Resources [SWN.V] did with cash, albeit after a testy and somewhat amusing removal of management by activist investors). This tells me that either: 

1. Management plans to spend cash to fully develop the mine at some point in the unforeseen future.
2. Management plans to continue milking compensation out of FOS for the foreseeable future. 

Either way, without some insight on the mine (of which I have none), sitting and waiting for an undetermined amount of time for management to become benevolent –even with a slow/nonexistent burn rate– does not look like a good risk/reward in my opinion.

The key here isn't the value of FOS (it’s a great value!). The key is the time value of money. “Waiting for an undetermined amount of time” for the return of cash is a speculation. The IRR can span from 23% in year 1 down to 5% if we don’t see any cash until year 4. For me to become interested (no real objective reasoning here), I want to see a 4 year IRR potential of at least 10% (~C$0.24/share for those keeping score at home, and coincidentally ~67% of net cash). Until then, I play the waiting game.

Disclosure: No Position

Harvest Investor © 2014. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

The Dangers of Coattailing

In her Warren Buffett biography, The Snowball, Alice Schroeder details how Buffett viewed the idea of borrowing ideas from other investors:

“ . . . he also felt honored to borrow ideas from Graham, Pritzker, or any useful source. He called that riding coattails and did not care whether the idea was glamorous or mundane.” (The Snowball, Schroeder, pg. 111)

Although Buffett took the idea and then went on to do in-depth research, many people skip the research, leading almost every blog and investment professional to recommend the now ubiquitous “this is not a recommendation, do your own research” disclosure in an effort to cover their rears (who would be so spineless you ask? . . . ahem . . . please see my disclosures below).

In my own personal investment process I take pride in doing my own research, no matter where the idea originated. However, upon some recent post-mortem analysis of my stock selections, I have to admit my experience with taking other people’s ideas has been nothing short of abysmal (it was so bad that I honestly didn't even need to do the post-mortem analysis, it was a glaring sore thumb). With a little introspection, I chalk my poor coattailing experience up to a weakness of mine (and perhaps, arguably, a strength): Laziness.

With coattailing, I often find that my objectivity gets swayed. A stock that, after detailed independent research, might rate as average to slightly above average suddenly becomes a search for what did I miss – there must be a reason XYZ fund or great investor so-and-so is buying. This takes me from a balanced view of the company to the lazy mindset of looking for what’s good about that company (because there must be something, right?) – a subtle shift, but a devastating frame of reference for an investor.

Even the big boys can get things wrong.
No one is immune from the occasional investing mistake. Take for instance the following quote from a July 2011 investor letter that I recently ran across while researching Mosaic (MOS):

“While we were drawn to Mosaic by the catalytic event of the Cargill sale, our position is now largely sustained by two main drivers. The first is our belief that grain and corn fundamentals are extremely positive. . . . The second is our belief that potash fertilizer has yet to recover to trend-line levels of demand.”

That quote comes from one of the most well known (and most successful, so don’t take this as an insult to them) hedge funds in the world. In the text, they clearly and concisely lay out their thesis for why MOS has “significant upside” at their cost of $65.

For an investor on the fence about MOS it would probably have been the push they needed to start buying. The nudge of a well respected firm/investor would move their psyche from “it’s an OK stock, but I just can’t get my hands around it” to one of “I must have missed something in my review, let’s go back again (and specifically focus on the talking points I've now heard).”

Here is what MOS has done since that letter was published:

     Source: Yahoo! Finance

(Full disclosure: I have no ideas when/if the hedge fund exited the MOS position. For all I know they may have exited with a profit).

Now as a long-term investor, I’m open to the fact that $65 may still be a great entry point, and the ability to buy on this weakness may be a gift from Mr. Market (in the form of a breakdown of the BPC potash cartel). [As an aside I've put MOS in the “too hard” pile (at least for now). Even though I think the balance sheet is strong and the valuation is somewhat attractive, I don’t have a good enough grasp of the potash cartels and the global reserves and mineable resources of P & K.]

All of that aside, if you had limped into MOS on what I’m calling a “laziness coattail” – one where your objectivity was swayed by someone else’s analysis and not backed up by your own – you’d be staring at a near 30% loss on a stock that you originally would have passed on. If your objectivity was cloudy at the onset there is almost no possibility that it’s any clearer now.

This issue closely relates to money managers talking their book. I have no problem with investors highlighting their best ideas. What becomes a problem for me personally (since it clouds my objectivity) is when they become stock salesmen and women. They talk up the stock’s growth prospects, the potential size of the global market, and the whiz-bang technology the company possesses. Yet, when it comes to the company’s risks – and make no mistake, every company has multiple risks – all you hear are crickets.

Again, these are subtle shifts, but I’d much rather hear what can go wrong (and the defenses the company has in place to offset) than what can go right (and be left guessing what risk will derail the company [if Donald Rumsfeld is out there, we can talk about unknown unknown risks another time]). To me this is what competitive advantages are: defining corporate characteristics that protect the company from risks.

To offset my own laziness and stupidity (I was going to say “improve my objectivity and discipline,” but those aren't the risks; laziness and stupidity are the risks) I’m changing my coattailing routine. No more chasing down prepackaged positive leads. No more limping into mediocre ideas on the back of “gurus.” Basically, no more laziness (I wish I could say no more stupidity, but a zebra can’t change its spots).

If I can’t study a company and say “wow . . . that’s stupid cheap,” I won’t buy it. I still plan to coattail and take ideas from anywhere and everywhere I can find them, I just need to be careful in how I react to those recommendations. [As an aside, “stupid cheap” doesn't mean I only buy net-nets; quality stocks can also qualify.] If I can do a better job of remaining objective, the old axiom of “focus on the downside and the upside will take care of itself” should allow my “stupid cheap” ideas to outperform over the long-term.



Harvest Investor © 2013. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Gladstone Land: A Farmland REIT Emerges

Gladstone Land (LAND) is a recently public farmland investment company.  After publishing an off the cuff tirade about farmland REITs back in 2011 (this blog's most popular post ever - by a wide margin), I decided that LAND deserved a look.  Of course the 8.5% dividend yield may have piqued my interest as well, but more on that below . . . 



LAND 5-24-13 -



Harvest Investor © 2013. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Rocky Mountain Dealerships (RME)

Summary 

After reviewing my holding in Rocky Mountain Dealerships (RME) I continue to hold my position but am no longer accumulating shares. I am willing to swap-out the position if I find a better value opportunity, but I am not at this point liquidating shares to move to cash.

Background 
I originally purchased RME 2 ½ years ago and since then it has been a good (but not great) holding for me. However, after Titan Machinery’s (TITN) bloodbath recently, and after seeing a number of analysts upgrading RME in recent months (which frankly scares me), I thought now would be a good time to step back and review my thesis on the stock, its valuation, and what could go wrong.

Company History 
RME is an agricultural and construction equipment dealer. It primarily sells Case IH, Case Construction, and New Holland brands (as well as a number of “short” lines) through its 39 locations across Alberta, Saskatchewan and Manitoba.

Back in 2006, Matt Campbell (CEO) and Derek Stimson (President) merged their respective Hammer Equipment (primarily construction) and Hi-Way Service (primarily ag equipment) into one company and IPO’ed the firm in late 2007. Since then, the company has been on an acquisition spree, purchasing 15 independent dealerships since 2008. In 2012, sales broke down as (from 2012 annual report):

The strategy behind RME is beautifully simple. A larger dealer network can command better operating efficiencies and cost management than smaller, independent (“Mom & Pop”) dealerships. Management has noted that their target performance is a 15% (maybe up to 17%) gross margin with ~10% SG&A expense netting a 5% operating margin. This compares to small dealerships which typically have ~11% gross margins and an 8-9% SG&A overhead for a 2.5% operating margin. 

Now I’m usually very skeptical of economies of scale arguments, and this alone wouldn’t have gotten me to invest in RME. However, the economy of scale argument with a clear path to market share growth was more compelling. With its ability to dramatically improve margins, RME has been able to aggressively acquire its competitors, while still keeping acquisitions accretive to earnings.

Most importantly (in my mind), RME’s primary supplier (Case New Holland) supports a roll-up of small dealerships. Comments from equipment executives show that the big manufacturers (Case, Deere, Cat, etc.) want larger dealer networks for their own efficiency and operational reasons. When you have a better operational structure than the competition (higher margins), a deep pool for market share growth (acquisitions), and a franchisor (who effectively controls market share) in favor of a dealership roll-up, that’s a powerful business model.

All of this led to 2012 being a banner year for RME. Same-store sales were up 16.3% on the year. The company posted record EPS of $1.28, up 24% year-over-year. On top of this, there was a fair sized debt conversion expense in the year. If I try to adjust for this, I get “normalized” EPS of $1.45 (up 41% yoy).  Suffice to say, the ag economy on the Canadian prairies is booming ($8.00 wheat creates a nice cash flow). But are these types of EPS numbers sustainable?

Risks/Concerns 
The problem for RME is that acquisitions have fueled their growth, and those acquisitions are getting harder to come by. A quick search of the Case IH website reveals 27 ag dealerships listed in Alberta, and 18 of them belong to RME (67%). Saskatchewan may be an opportunity with 25 dealers listed and RME accounting for only 5 (20%), but there are other fairly entrenched dealerships in the province to compete with. Manitoba is similar to Albert, with 12 dealerships listed and RME accounting for 7 (58%). The company could jump south of the border into the U.S. for growth, but there is intense competition there from companies like TITN. There may also be room for RME to grow its New Holland presence, but that remains to be seen. 

Beyond growth, there is the always present worry that a downturn in the ag economy will hurt the company. We can argue about long-term ag environment and Malthusian trends, but that’s not the road I want to take today. What concerns me about a slowdown in ag spending is the following slide that RME management has often used regarding combine sales and the lifecycle of a combine: 

Combines are at the top end of the agricultural equipment food chain. New machines are running at or near $500,000 depending on options – in other words a major capital outlay. 

As the industry shifted away from leasing machines a few years ago (because that put the risk back on the equipment manufacturers [i.e. Deere, Case, Cat] balance sheet), dealers devised this ingenious lifecycle pyramid. The problem with pyramids, if my memory of stacking blocks in pre-school serves me right, is that it’s not the top of the pyramid that is important, but rather the base. 

I pulled some of the data from the above slide to generate the following table. Some of the estimates are my own / backed into to make the math work. 

What we see is that there are ~3,000 ~2.1 yr old machines sold annually (in Canada). There is demand for ~3,500 of those machines (from midsized farms). Basically, the slide is saying that there is a market imbalance. As an aside - I see this demand discrepancy as responsible for allowing the corporate farms to buy new machines annually, run them for a year (on warranty), and then sell them 12-24 months later without seeing much depreciation in value (strong demand from midsized farms). Basically the corporate farms are profiting on the backs of the small farmers (wow . . . doesn’t that sentence sound very Marxist). But . . . if this is happening, why aren’t midsized farms jumping up and buying new machines? Is this what happened in 2012 – boosting RME’s EPS? 

How real the top-end demand discrepancy is (the market clears doesn’t it) isn’t what concerns me the most – what concerns me is the bottom end of the pyramid. Play with the numbers even slightly (change the avg. years in use of machines for small farms from 7.6 to 8, 9, or 10) and the demand drop for combines reverberates up the pyramid (i.e. at 10 years, the “small” farms only demand 2,675 machines per year). As this manifests up the pyramid it would be ugly for farmers and devastating for RME. I have a tough time quantifying how likely this risk is, but common sense would argue that a decline in the ag economy (whether macro, price driven, or even short-term weather driven) would bring on a lengthening in the life cycle of a machine (yes, I know, the lifecycle for a combine is not 13.4 years – you can buy a 2000 model machine for ~$80,000 right now – not $0, but the theory/math holds no matter how you slice the lifecycle). 

Also, rival TITN machinery (based just across the U.S. border in Fargo, ND, and with 106 U.S. based dealerships) showed us recently what happens when the roll-up strategy stalls and margins contract (Midwest drought). The risk of margin contraction is inherent in the tight working capital situation of dealerships. Financing inventory on a floor plan is great when the business is booming, but floor plans add insult to injury when inventory turns slow and the bankers start demanding payments or additional collateral to maintain the line of credit. 

All of this leaves me asking what will drive growth in the future? As acquisitions dry up, market share will be hard to grow, and without market share growth, overall sales shouldn’t grow at much more than GDP type rates. 

Valuation 
The rub with RME is that it is cheap. Whereas TITN whiffed its earnings and investors are punishing it by rerating its P/E down from 14-15x to the current 11x, RME only trades at 9.3x my normalized $1.45 2012 EPS (adjusted for debt conversion expense, new long-term debt, 28% tax rate, etc.). If we look in terms of EV/EBITDA (adjusted for the debt conversion in 2012), RME trades at just over 3.0x. Of course, this assumes that the company’s floor plan is a payable (not included in EV) and not debt (included in EV). If I include the floor plan in EV, the ratio jumps to 9.5x. 

Free-cash-flow is also strong. If we assume depreciation/amortization and capex offset one another, than FCF is equal to net income. Last year an adjusted $1.45 in EPS would equate to a FCF yield of 10.7% - not too shabby. 

Catalyst 
I have a tough time coming up with readily achievable catalysts for RME: 

• Further acquisitions are an opportunity, but the low hanging fruit has already been harvested. Growth into the New Holland line or geographic expansion might surprise me, but these come with new risks and the possibility of cannibalization. 
• Margin expansion may be an opportunity. Management argues that 5-6 years after an acquisition the company’s gross margin should increase from ~15% to ~17% on a “larger installed equipment base” driving an “increase in high-margin product support revenue.” However, like acquisitions, the low hanging fruit is already gone and a 15% gross margin is consistent with what peers earn.
• Long-term growth in the ag sector is an arguable catalyst, but with 16.3% same-store sales growth last year and my own worries about things like the combine lifecycle identified above, the industry may have pre-run this catalyst.
• Free-cash-flow is the most obvious catalyst, with management conservatively being able to throw off $1.00 - $1.50 a year in FCF (7.5% - 11% yield), but this is somewhat offset by the risk of a low margin business in a cyclical industry using a floorplan payable for a large part of its financing. 
• Value is often ridiculed as its own catalyst (cheap can get cheaper), but it’s hard not to argue that RME is a better value than peers. 

Updated Thesis 
My thought process is all over the place in this post – you can see me blindly stumbling around looking for an answer on this one. It just goes to show you that the sell decision is often much harder than the initial buy decision.

Although I’m no longer an accumulator of RME shares, I am not at the point of liquidation either. For my portfolio, I will replace RME shares with better opportunities as they present themselves, but I won’t sell RME to move to cash (yet). Maybe that’s just a cop out (a “hold” recommendation . . . really . . . I’m disappointed in myself), but I continue to view management’s ownership (~22%) and the value as weighted against the risks of slowing or declining sales, weakness in the ag economy, and the overall tight margins of the business.

Disclosure:  Long RME

Harvest Investor © 2013. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Eagle Bancorp Montana, Inc. (EBMT)

Eagle Bancorp (EBMT) is the bank holding company for American Federal Savings Bank, a community bank based in Helena, MT. The company has 13 branches, primarily along the I-90 corridor in southern MT. As of Dec. 31, 2012, the company had ~$508 million in total footings and a market cap of roughly $40 million. 

EBMT has twice been written up on Value Investor’s Club, and the analysis put together by the two authors shames my feeble attempt, so I urge you to review those write-ups (both are available to “Guests” who register for a password). The most recent write-up from February 2013 does a nice job of explaining what’s happened recently with EBMT, specifically the acquisition of 7 branches from Sterling Financial in July 2012.

To recap, EBMT purchased: 

• 7 Branches (Missoula [2]; Hamilton, Bozeman, Livingston, Big Timber, Billings) 
• These complement the bank’s existing 6 branches (Helena [3], Townsend, Butte, Bozeman)
• $44 million in performing loans. 
• $182 million in deposits. 

Management paid a 4.3% deposit premium for the acquisition (EBMT paid Sterling $7.92 million for $182 million in deposits). The acquisition put to work excess capital that was raised with the second-step conversion back in 2010 (Equity/Assets dropped from 16.4% in June 2012 to 10.5% as of Dec. 31, 2012).

Beyond the branch acquisitions, another notable point regarding EBMT is its anniversary. On April 5, 2010, the bank completed its second-step conversion from a mutual holding company to a fully publicly-owned stock holding company structure. Without getting into the fascinating world of bank regulations (ZZZZzzzzzzzzzz), we can sum up to say that the OCC (savings bank regulator) severely limits a mutual company’s ability to be acquired in the three years following conversion. As of April 5, 2013 (what a coincidence – that's today!) those restrictions are eased (I say eased because this is still a bank, and the Federal Reserve Board (holding company regulator) / OCC (bank regulator) would still need to sign off on any acquisition). 

Now, my 2 cents: 

1. The Sterling acquisition is not the slam dunk it appears at first blush. The cost of the deposits acquired ($182 million) was 0.72%. Doesn't sound like much does it? Yet, ~57% of those deposits were money markets, DDA, NOW, and savings. Those should be yielding ~0%. The ~43% in CDs would then have an implied yield of 1.67% - not exactly cheap money (I know, I know, 1.67% is cheap money in a normal environment, but the Fed’s ZIRP is anything but normal). Consider that a quick internet search reveals that I have to go out 5 years to get in the 1.50 – 1.75% on a CD right now. The reason for the heightened cost of acquired deposits is due to Sterling Financials problems in the financial crisis. Sterling was literally trying to avoid a run on its banks, and jacked up deposit rates to avoid insolvency (go look at its stock chart). Although I think EBMT can hold on to many of these deposits, it might not be perfectly smooth/easy/cheap.
2. Although I like the idea of a potential acquisition catalyst, I’m not sure how high a probability we should assign such an outcome. From conversations with Montana bankers, there isn't a good in-state acquirer. Most of the other local institutions already have significant footprint overlap with EBMT. On top of this, the Sterling branches were shopped to everyone. EBMT didn't so much score a coup by grabbing them, but rather they were one of only a handful even interested in the branches (which makes the 4% deposit premium look a little expensive in my mind). Still, I'm not much good at identifying potential acquirers beforehand. Perhaps a mid-sized out of state institution wants into Montana, but I'm not building an investment thesis on it. 
3. EBMT held up remarkably well in the financial crisis. I love a bank with solid underwriting. Just look at the ratios: 

	Jun 05	Jun 06	Jun 07	Jun 08	Jun 09	Jun 10	Jun 11	Jun 12	Dec 12
NPL/Loans	0.47%	0.32%	0.13%	0.02%	0.75%	1.65%	1.57%	1.83%	0.70%
ALLL/Loans	0.53%	0.38%	0.33%	0.31%	0.31%	0.64%	0.96%	0.93%	0.85%
ALLL/NPL	114.4%	116.6%	244.3%	1641%	41.9%	32.1%	44.0%	29.1%	121.4%

NPL = Nonperformg Loans; ALLL = Allowance for loan and lease losses

Close (geographic) peers like GBIC and FIBK saw NPL/Loans spike to 4.5% to 7.8% in the 2009-2011 timeframe. 

Now some people are criticizing EBMT because they won’t be able to juice earnings with reserve releases as NPLs come down and the economy improves (FIBK/GBCI are now running ALLL/Loans at 2.5% - 3.85%, with ALLL/NPL of 100% - 130%). Although technically true, that’s just an accounting game. Games can influence short-term investors (a catalyst), but over the long-haul, I prefer the bank that never had to jump on the reserve/release roller coaster.

The stock looks moderately cheap if we think a number of things can go right:

• (A) Leverage improves. As noted above, EBMT has now deployed some of its excess capital. This should help improve ROE levels by up to 50% (Assets to Equity improvement from 6.1x to 9.5x = 56% improvement). 
• (B) The potential to write-new loans. Right now, EBMT is under-loaned at a loan/deposit ratio of 52%. Historically, the bank has run at ~75% loan/deposits. If they jumped up to a 75% ratio, this would be $97 million in new loans. I do not want them to do this quickly (I worry about underwriting standards), but even assuming a 5-10% increase in new loans annually that’s a $450,000 benefit to the bottom line and a 9bps boost to ROA annually (assumes $15 million in new loans annually, a 3% margin on new loans [consistent with most recent 10Q loan yield of 5.4% less securities yield give-up of 1.4% and a 1% hit for oversight costs = 3% yield increase] divided by $508 million in footings). 
• (C) Now the question of what is a normalized ROA confronts us. Over the last 10 years, the bank has averaged 0.83%. Over that same time, the bank has posted an average efficiency ratio of 72%. This is inexcusable – peers (no, not management cherry picked peers, but rather banks right across the street from EBMT) are sub 60%, with a number below 50%. Whether through its new larger size, or just better control of the purse strings, EBMT needs to get down to 60% (as a side note, this is where I think an acquirer might salivate – it should be feasible to buy EBMT and quickly improve the profitability). A drop from 72% to 60% in the efficiency ratio would foster a 40% increase in ROA. Using the 10 year average 0.83% ROA, a 40% increase would indicate an ROA of 1.16%. Let’s use 1.0% to be a little more conservative. 
• (D) Let’s put it all together. Now points B & C overlap somewhat (historically, EBMT has run at a loan/deposit ratio of 75%, so I can’t assume loan growth will increase ROA above the 10 year average). However, just looking at point A, which is an Asset/Equity ratio of 9.5x, and point C, which is an implied ROA of 1.0%, we get an ROE of 9.5%. If we want a 10% return on our investment, we can afford to pay 0.95x book value. At 0.8x right now, we’re buying EBMT at a near 20% discount.
• (E) If we look back at the good old days before the financial crisis (2002-2008), EBMT had an average ROA of 0.89%. A 40% efficiency ratio improvement would get this to 1.25%, ROE to 11.88%, and an implied P/B ratio of 1.2x, which is 50% above current. 

Bottomline, I think EBMT is undervalued trading at 0.8x book value. It’s not incredibly cheap on an absolute / right now basis, but it has solid long-term potential, as well as a number of catalysts (acquisition integration, efficiency ratio improvement, improving economy, etc.) that should help it improve operations. Most importantly, management has historically been a top notch underwriter, which provides downside protection (margin of safety).


The importance of solid underwriting brings to mind an old J.P. Morgan quote. In December, 1912 Morgan testified before congress and was asked how he decided whether to make a loan. He replied, “The first thing is character.” One of the esteemed congressman suggested that perhaps factors like collateral might be more important, but Morgan retorted, “A man I do not trust could not get money from me on all the bonds in Christendom.” 

Disclosure: Long EBMT

Harvest Investor © 2013. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advices, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Ceres Global Ag: Of Activist Investors and Asset Sales

A lot has been happening with Ceres Global Ag recently.

In addition to the export hub announced in early February, on March 11th management announced that they were selling the Ralston, WY facility (and the Powell, WY seed plant) to Briess Industries – a Wisconsin based maltster. I have to admit I was somewhat surprised by this announcement as Ralston was (1) a more recent purchases by Riverland Ag (September 2010), (2) likely (although management doesn't break out profitability by facility) one of the better earning assets for Riverland, and (3) an interesting move for a company actively looking to put cash to work in “high-quality grain storage facilities.” To wit (taken from page 4 of the 2012 Annual Report): 

“For example, the facility we’ve acquired in Ralston, Wyoming complements our grain storage business by giving us additional capacity on the western edge of the U.S. heartland.”

And later on the same page: 

“We anticipate similar investments in the coming years as we investigate opportunities in grain and logistics infrastructures.” 

Keep in mind, this is page 4 of the annual report, not some buried footnote on page 52 (hint . . . remember that page number). Page 4 is where they talk about the overall operating strategy for the entire company.

Now, in fairness, maybe management has a viable reason for this sale. The far Western geographic location may have played a factor, as well as the facility’s status as a country elevator and not a terminal elevator. The not well disclosed sale of Riverland’s country elevator in Iona, MN (see page 12 & 14 of the 3Q13 MD&A) would be consistent with this strategy shift, indicating Wahpeton, ND may be on the chopping block as well. Still, to have bought the Ralston in September 2010 and to turn around and sell it in March 2013 (2 ½ short years, but who’s counting) has to be an egg on the face event for Ceres management, and even more important to shareholders, a fairly major shift in the company’s overall strategy.

There may be another reason management is scrambling to right the ship. Remember page 52 of the AR? That just happens to be where “Management Fees and Other Expenses” are discussed. And management fees are at the center of an activist campaign recently launched by hedge fund VN Capital. This morning’s story by The Globe and Mail is the first real media coverage of the battle.

The crux of the campaign is to eliminate the 2&20 hedge fund management fee extracted by Front Street Capital for providing oversight to Riverland Ag and the other portfolio investments. I have been fairly upfront on my thoughts regarding this issue. From my post on June 15th 2012: Ceres Global Ag (CRP): 4th Quarter and Fiscal 2012 Update: 

“One last item – still the biggest issue facing CRP, in my humble opinion, is the dual management structure. A low margin business in a commodity industry cannot sustain the SG&A expense of maintaining two management teams (Riverland Ag and Front Street Capital). This is a key factor to watch going forward.” 

VN Capital appears to have run out of patience on this issue – a move which I personally applaud. Where the activist campaign goes from here, I don’t know. At this point, my limited knowledge of corporate governance would tell me that it depends on how Ceres Board of Directors, particularly the independent directors respond. Do we move toward the special meeting that VN has called for (to hold a vote on the termination of the management contract with Front Street Capital), or does the BoD dig in its heels and we move toward a proxy battle. Proxy battles are long, messy, and – most importantly - costly affairs (look at Jana Partners and Agrium). Hopefully that can be avoided, and a shareholder friendly resolution can be achieved in the coming weeks.

I encourage anyone out there who is a shareholder in CRP to pay attention, watching for (and reading) any information circulars or proxies from the company, VN Capital, or other interested parties so that you can draw your own conclusions in the coming weeks/months.

Full Disclosure: Long CRP

Harvest Investor © 2013. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Real Estate: Carrying Value Concerns

An article earlier today about AMD selling its “Lone Star Campus” in Austin got my attention. 

Now I have no opinion on the merits of AMD’s sale lease-back on this property, its impact on capital and working capital, or the value of the property. In fact, I know very little about AMD in general (outside my circle of competence). 

However, what I found interesting was the last paragraph of the press release:

“The company expects to record a special charge of approximately $50 million in the first quarter of 2013 primarily related to the difference between the sale proceeds and the carrying value of the property.” 

A $50 million loss on a property is a big loss. How the $50 million is calculated I don’t yet know (perhaps more info will come in the 1Q13 10Q), but a quick web search indicates that the facility cost $190 million when completed in January 2008. Ignoring any depreciation, capital expenditures, additional construction on the facility, or potential that the $50 million loss is part of the sale lease-back incentive, the $190 million construction cost less the net sales proceeds of $164 million is still a loss of $26 million (14% of original cost). 

Many value investors – particularly investors buying stocks below book value (myself included) – get into the shorthand habit of assuming that the market value of real estate is always worth more than the balance sheet carrying value. I've often heard this argument trotted out in relation to retailers – the business may be declining, but the real estate is worth multiples of its carrying value. In an economy coming off of the biggest housing bust since the Great Depression, we need to check that logic and be double sure the real estate is even worth its financial statement carrying value. 

I guess the point here for myself is to not shirk the due diligence process. From the income statement to the balance sheet, facts and figures need to be checked. As an old acquaintance of mine used to say, “Trust everyone, but brand your cattle.” 

Disclosure: No Position

Harvest Investor © 2013. All rights reserved. The content and ideas contained in this blog represents only the opinions of the author. The content in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. No content shall be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The author may hold positions in the securities and companies mentioned on this site. Any position disclosed on this site may be modified or reversed without notice to you. The content herein is intended solely for the entertainment of the reader, and the author.

Village Farms International (TSE:VFF)

VFF is a name I’ve run across in the past but didn’t spend much time analyzing until it hit my radar with disappointing results and a swift sell-off in May. Since that time, the stock has done nothing but go down – off over 50% in the last 3 months as the news just gets worse and worse. Suffice to say, we have a company with bad news in the short-term offset by solid operating results historically; a one-time act of God disaster severely impacting operations; and a stock price falling through the floor. Isn’t this the definition of a value stock? That’s where I started my analysis . . .

VFF bills itself as “a leading grower and marketer of branded, high-quality hydroponic greenhouse grown produce in North America.” Basically, the company grows tomatoes (and to a lesser extent cucumbers and bell peppers) on a large scale. When I say large, I really mean it – these aren’t your typical local flower farm greenhouses. VFF’s 8 facilities in British Columbia and Texas cover a staggering 262 acres. Go to Google Maps and search for Village Farms in towns like Fort Davis, TX or Marfa, TX to get a real appreciation for the size of these 40+ acre buildings.

The VFF story is an attractive one in terms of sustainability and long-term production growth. Greenhouse grown tomatoes yield over 50x per acre that of traditional field grown plants and use an estimated 85% less water (via water recycling). With growing demand for arable land and drinking water, the long-term trend seems to favor high impact growers such as VFF. On top of this, greenhouses can be located adjacent to key population areas and/or low cost energy sources - reducing food miles, carbon footprint, and meeting a growing “buy local” trend among North American consumers.

VFF also owns a propriety technology known as GATES (Greenhouse Advanced Technology Expert System) – a fully enclosed greenhouse technology capable of sustaining year round production at feasible cost and scale levels (as compared to traditional greenhouse production which goes “dark” for 3-4 months each year depending on location). GATES is so efficient that it is estimated to provide production levels 60% above traditional greenhouse systems. The company already has one greenhouse fully operational under GATES technology (Monahans, TX; 30 acres of tomatoes on-the-vine). Beyond the ability to expand its own production through greenhouse conversions or new builds (at considerable capital expenditures of course), VFF has the option to license GATES technology to competitors. To date, VFF has shown little interest in licensing GATES, but it remains an asset that doesn’t fully show up on the balance sheet.

Speaking of the balance sheet, what really sticks out on VFF is the valuation. At a recent close of $0.66, it trades at only 0.53x tangible book value ($1.25 as of 6/30/12). On top of the discount to TBV, the balance sheet likely understates the true replacement value of the greenhouses VFF owns.

We get a real time look at what the replacement value (using insured value as a proxy) of the greenhouses is due to recent damage on one of the facilities in Texas (see below). The damage resulted in receiving $18.7 million in insurance proceeds (with more pending/expected), but only a $3.9 million inventory write-down and an asset write off of $2.8 million – meaning the balance sheet had been undervaluing the greenhouse(s) in Marfa, TX by at least $12 million (assuming management has taken appropriate balance sheet write downs – a question I have not specifically addressed with them).

At stated balance sheet levels, to get a 10% return on our investment at the current share price, all we need is for VFF to earn an ROE of 5.3% (10% * 0.53x P/B). Last year, reported ROE was 14.8%. Also in calendar year 2011, VFF earned EBITDA of $15.5 million. At a current enterprise value of $104.983 million (38.873 million fully diluted shares outstanding at $0.66 per share plus $80.654 million in debt less $1.327 million in cash) we get an EV/EBITDA ratio of 6.8x – cheap for a growing enterprise.

Yet, as I noted above, things have not been going well for VFF. For the quarter ended March 31, 2012, VFF announced a 17% decrease in the average selling price of tomatoes year-over-year. The second quarter was no better, with management announcing that tomato prices were off 24% year-over-year. Intense pressure from field grown Mexican tomatoes (VFF management goes so far as to define the Mexican production as “dumping”) has been the primary culprit behind the weakness in tomato prices.

On top of this, a hail storm passed through Marfa, TX on May 31, 2012 severely damaging the 82 acre facility located there. Although insurance proceeds have been received (with the potential for further receipts) and one greenhouse (approx. 40 acres) has been repaired and is again operational, the fate of the remaining 42 acres in Marfa is up in the air.

This leads me to the three things keeping me out of this stock right now:

1. The balance sheet: debt to capital sits at 60%. For calendar year 2011, Times Interest Earned (TIE) was 3.1x, but the weakness in tomato pricing has caused TIE to go negative in recent quarters (net of the insurance proceeds in Q2). The weakness has so depressed operating earnings that VFF is nearly in violation of its debt covenants. Management was specifically asked about this on the recent quarterly conference call, and noted they were within all parameters currently – but didn’t go into detail on whether the covenants had been restructured or were in danger of being enforced.  If the market is right and the assets of VFF are not worth the balance sheet values but are rather worth $0.53 on the dollar (a case in which management should hope for further hail storms given the insurance proceeds they’ve received to date), then the debt/capital ratio would jump to nearly 77% - not much margin of safety.
2. Live by the government, die by the government. VFF is a leader in lobbying to regulate / legislate the “illegal dumping” of Mexican tomatoes into the U.S. Whether such lobbying is good/bad/indifferent, I’m not a fan when a company’s business plan requires government intervention to eliminate lower cost producers – in fact, it’s a red flag. With one stroke of the pen government intervention can create a competitive advantage, with another stroke of the pen it can completely destroy that competitive advantage (ok, I’ll admit that I’ve been burned by similar circumstances in the past and am cynical!).
3. The lack of a clear future operating strategy. As of today, even management doesn’t know (or at least isn’t saying) if they’ll rebuild the second greenhouse in Texas damaged by hail earlier this year. They may use further insurance proceeds to pay down debt, they may rebuild, or they may build a new GATES facility. The lack of clarity on the operating strategy – more than likely influenced by an already leveraged balance sheet with little room for additional borrowing – is a red flag that VFF may not have a sustainable competitive advantage in its current form (GATES may be a sustainable competitive advantage, but if management would need to issue (dilute) equity to realize the benefit, is it a real advantage in its current form?). 

Bottom line, I think VFF is extremely attractive in terms of historic earnings power, potential growth, and the value of assets on the balance sheet. In fact, it likely presents an asymmetric risk/reward payoff (downside of $0.66/share and upside of $2.00/share+). However, when the downside is a complete loss of capital, I’ll pass. Until we get some clarity on the future operating strategy of the company, until the impact of Mexican tomato production is better known, and until the balance sheet is stronger (or at least some combination of those three criteria), I’ll sit on the sideline.

Disclosure: No position in VFF but I reserve the right to implement one at any time.

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