Keybridge Capital Ltd Convertible Notes (KBCPA)

Regular readers will know of my interest in different types of securities like bonds, preference, hybrids, convertibles and so forth. As noted in previous posts, I wish there were more of them. Well structured and well priced alternate securities can offer investors a cracking deal especially in circumstances where downside is structurally limited (think WESN (now longer listed) and AFIG for example) and fundamentally limited with upside potential. Unfortunately there aren't many on offer (in Australia) and none really at a decent discount in this market. 

But please don't take my word for it - just look at the doyen himself, Warren Buffett. A great example of an alternate investment he made is Goldman Sachs (GS). Back in 2008 Buffett bought US$5bn of GS 10% p.a. preferred stock which included warrants to purchase a further $5bn ordinary GS shares at at a strike price of $115 anytime up to five years from date of issue. So that gave him the right to buy 43.5m shares for $115 which based on the current price of US$212 would have been a profit of $4.2bn. Interestingly, the deal was amended in 2013 so Buffett ended up with 13m shares but didn't have to pay for them (now worth $2.8bn plus his preferred's). That's a great deal.   

Apologies, I digress - back to the story. 

One new stock that doesn't fit the bill of upside optionality, but is interesting nonetheless is KBCPA. KBC is issued by the mother-of-all magnets to the value community - Keybridge (KBC). KBC itself is a collection of all sorts of investments all over the world. Please note it is not the purpose of this post to explore KBC - that is a long story in itself. KBC has a market cap of $27.8m (17.5c). The new KBCPA were issued at $1 in June and there are 5m on issue. 

KBCPA were actually issued to existing KBCPA shareholders as an in-specie (non-cash) distribution on a 1 for 36 basis. Why? There are a number of reasons. It provides additional funding in the future - i.e. issue more KCPA to help fund a project. This is smart - the notes are unsecured and provide debt without the banks placing restrictive debt covenants. More directly, the notes appear to have been a way to return some excess capital to shareholders without actually handing over any cash! Instead of KBC's cash going down, debt goes up. The effect to net equity is the same however they retain the cash to invest. And also quite smart is the new channel it creates to pay out franking credits. The notes are 7% fully franked meaning lots of franking credits for holders. 

So on a grossed up basis, the yield is 10% p.a. which is really attractive in today's market. A 10% p.a. yield is roughly the same as the long term combination of growth and dividends from the stock market - so you can understand if investors interested is piqued (especially if you think KBC is pretty safe). Even as I write, a few have trade above the issue price. 

For me, I want upside potential. Either through favourable conversion terms such as a fixed exercise price (see the Buffett deal) or a discount to the face value (in cases where the maturity term is fixed as is the case with KBCPA). Who knows, maybe the market will get really scared for some general reason or Nick Bolton stuffs something up and they get sold off well below face value. But for the time being these conditions are not present so it's a pass for me. 

Kristian 

Disclosure: no position in the above names

Redhill Education Ltd (RDH)

RDH was recommended to me by a friend about 5 years ago. I didn't buy and haven't really followed the stock for years now, however I  was recently reminded of it when researching another education company. Anyway, I've just finished reading through the annual reports back to 2010 (when it commenced life as a listed company), along with the 2010 prospectus and the cataclysmic earnings downgrade in 2011.  

The stock has presented tremendous opportunities to both lose and make money, and I think its history is both incredibly interesting and informative. You can see what I mean from the graph below: 

Source: Yahoo Finance

RDH listed back in September 2010 for an issue price of $1. 

RDH was already an existing company of two education businesses. The $16m capital raising was to buy two more education purposes and so creating a horizontally integrated business of what looked like quite different educational units. The CEO and CFO were new to the business. Original shareholders do not sell their shares into the float and put their stock in escrow. The prospectus (August 2010) forecast pro-forma 2011 Revenue $21.4m, EBITDA $4.9m, NPAT $3.4m, 12.6c EPS and a 3c DPS. No debt. Compared to an initial market cap (non-diluted) of $27m, this all looks pretty cheap and the stock rallies to $1.24.

So far, so good. 

7 February 2011 was a shocker. RDH downgraded in a massive way. FY11 forecast EBITDA was cut down from $4.9m to $1.1m. That's massive. All sorts of reasons were given for the downgrade: 

The stock tanks from 77c to 23.5c (note it had been drifting down from $1.24 to 77c from September to February). The CEO resigns later that month. The price keeps drifting lower to 10c in June 2011 tallying a 90% loss for investors in the float. FY11 does indeed turns out to be a shocker posting a pre-tax $3m loss although operating cash-flows are only just negative. The market cap is $3.5m v book value of $15.1m. 

Fast forward to FY12. New CEO (one every year so far). Lots of restructuring. Lots of write downs to assets. Book value drops from $15m to $6.7m. The stock wallows at 9c. Operating cash-flow is actually slightly positive - most of the P&L is hit by write-downs to the balance sheet in different areas. 

So what it looks like so far is a revolving door of management, macro issues and all at the same time trying to bed down two simultaneous acquisitions. You wouldn't touch it with a barge poll, right? 

FY13. The stock has more than doubled to 21c when the preliminary full year figures are released (July 2013). The numbers are looking much better. Revenues up, EBITDA is positive and operating cash flows are an impressive $1.6m. Lots of cost-cutting, new products, re-structure and possibly a better macro environment. At a market cap of ~$6m, the stock is starting to look cheap. 

FY14. The company reports a blinder and the share price has moved up to the $1.40 range. Revenues up 19%, NPAT is finally positive, EBITDA $2.7m and $3.2m in operating cash-flows and $6m in the bank. Just think the whole company was worth $3.5m in FY12. 

And forecast FY15 has more of the same big improvements. 

Note the original prospectus numbers have still not yet been met. 

So there was potentially a 14x return there. More conservatively 5-7x if you were buying as the positive news started rolling in 2013. 

Kristian 

Disclosure - no position in the above name(s)

United Overseas Australia Ltd (UOS)

This is probably the best Australian growth stock you've never heard of. Full credit to Nigel and Max (who also works at Harness) for pointing this stock out to me. The long-term performance of this stock is truly outstanding and its future continues to look bright. I recently took a position on a long-term view, and if you are looking for a good write up on the stock, please check-out the article on the Harnesss website. 

Kristian 

Disclosure: own UOS 

Do you know which stock this is?

Imagine you bought the stock below roughly near the bottom at 40c on the left hand side of the graph. 

That was March 2009 and the bottom of the GFC when the sky was falling on our heads. As we know, the market then rallied in a big way and this stock went nuts climbing up to $1.94; a close to 5 bagger on your investment. Can't think of anyone who wouldn't be happy with that. 

Move forward to 2011; a grinding year where the S&P ASX 200 almost hit 5,000, but didn't and then just headed south for the rest of the year to breakdown below 4,000 and wallowed there along the bottom. So too has the stock retreated all the way back down to $1.20; a spicy 38%. 

Throughout this time the stock was never 'cheap' on a traditional value basis. In fact, even though it had been around for a while, it was still not making money in 2009 and was hardly making any in 2010 and 2011 giving it a PE in the 30's. It wasn't paying a dividend during this time until September 2011 when it paid 1.5c. The fixed cost base was high for its industry. Management had an excellent reputation but this was a relatively new venture for them and had to yet prove themselves. 

Traders were probably already stopped out at this point. Fundamental investors might be wondering why they are holding this thing. If you hadn't already bought it, and as a good contrarian value investor your wonder who would buy a stock that has already moved up in orders of magnitude and wasn't cheap. You would look pretty silly if you bought it and it went down, right? 

Check out the graph below, which shows the continuation of the graph above - i.e. the subsequent performance of the stock:

You can see the subsequent performance is outstanding. And during this time the stock started paying dividends, so Total Shareholder Return (TSR) is actually much higher. Let's put some numbers around this performance. Assume you bought it at $1.50 in May 2011 - roughly halfway during it's decline after peaking at $1.94 in early 2011. The current price of this stock is $18.49 and has paid out $1.47 in dividends including franking (all of the dividends have been fully franked) so the total pre-tax return is $19.96. Not bad for a $1.50 investment. That's a 13 x return on your investment. IRR is  a blistering 142% p.a.

And remember, this is buying it after it had already increased several times over, so you have by no means picked the bottom.

This is not a nano cap that nobody had heard of.

So which stock is this? 

The stock is Magellan Financial Group (MFG). MFG is a funds manager that was launched after the founders noted that Australian investors were underexposed to international shares and Platinum had that part of the market to themselves at the time. That was correct - I was once-upon-a-time a financial planner and Platinum was seen by many as the only real serious international equity manager that wasn't a closet index hugger available on investment platforms. MFG have done a superb job at building a quality team and have built the business into a serious funds manager with $37.2bn FUM. It's an outstanding success story.

For investors, I think there are several lessons from the meteoric returns of MFG:

Scaleable businesses are amazing but patience is required

Funds management is massively scaleable. Just like software and franchise businesses. However they may not make much money to start with, so it's important to take a long term view of the company. More importantly than the short term financials is the top line growth. Can management build revenue? Is there macro head/tailwinds? What is the competitive environment to stop the top-line being grown? If the business is genuinely gearing itself up for massive growth, then quite possibly the short term financials may actually be quite poor as investment is made into product, people and marketing.

Don't be afraid of heights

It doesn't really matter if the stock has already increased several times over if the story stacks up. You would still have made a massive amount of money even if you bought at the interim top in early 2011. Personally I think looking at charts can sometimes cause false vertigo as it puts a frame around your perspective. Look again at the first chart and honestly ask yourself whether you would have thought the performance would have been what you see in the second graph.

Diamonds in your back yard

Ironically, MFG was set up as an international funds manager yet itself has proven to be an absolute diamond of an on the ASX. And just look at how many fund managers are pushing their clients to invest overseas using the sales pitch of a bigger pool and more growth offshore. This may be true, but you only need one MFG in your life...

Inverse of a cigar butt

As noted, MFG never looked particularly cheap on standard value investor metrics. You really needed to take a longer term, DCF view to see the potential. This is the same with most growth stocks to be able to get your head around paying a PE of 20+ (if it's making money at all). Sure, growth stocks have been bid-up, so perhaps you could argue MFG and other similar growth stocks may not otherwise be at their current prices. But even a decent pull back in prices has still yield MFG investors obscene returns. However the main point is the reliability of the DCF. With a 'concept' stock it's a crap shoot. With simple(r), observable businesses like MFG, DMP and REA predicting growth is easier yet not obviously not fool-proof. 

Kristian 

Disclosure: no position in MFG. 

Contango Microcap Convertible Notes (CTN, CTNG)

It's been a while since I've had a good look through the ASX listed interest rate securities. These are found at the back of the tables in the AFR. See below for this weekend's (6-7 June): 

I tend to call all of these securities 'hybrids' including the corporate bonds, floating rate notes and convertible notes, although this is not strictly correct in some cases. As noted in previous posts, hybrids have been good hunting although the by and large the market is now more comfortable with this sector than five years ago and therefore there are less opportunities. Again, as previously noted I think there is room for more of these types of securities as there are a lot of investors who really just want income to help fund their retirement. 

One security that I like (but don't own) are the AFIG convertible notes: AFIG. I've written a few posts up on AFIG before here, here and here. On a similar note are the Contango Microcap Convertible Notes CTNG. Let's look at these in a bit more detail - starting with fundamentals and then structure.  

Fundamentals  

Contango Asset Management is a fund manager of both unlisted trusts and the listed Contango Microcap (CTN). The underlying performance of CTN has been solid (note these are pre-fee figures):

Source: Contango Quarterly March Update 2015

As you can see, CTN has been around over 10 years, and the market cap is $176m with 160m shares at a share price of $1.08. Pre-Tax NTA is $1.17 and post-tax NTA is $1.132. 

The company holds no debt except the CTN notes which we will come back to shortly. 

Like other good LIC's, CTN pays a healthy dividend stream of a minimum of 6% of NTA each year. Forecast full year dividends are 7.7c partly franked. So at $1.08 that gives a yield of 7.1%.

Anyway, all of this is pretty straight forward as a background to CTN. Let's move on to CTNG itself. 

Structure

CTNG is very similarly structured to AFIG. To be honest, if I were running a LIC I would seriously thinking about raising some debt in a similar fashion. 

In summary, here are the key features of CTNG: 

• Face value $100
• Current Price $102.85
• Unsecured
• Fixed interest of 5.5% p.a. (on face value, unfranked)
• Interest Payment dates are March and September each year
• Convertible into CTN shares at each Interest Payment date at a rate of $100/$1.30 = 76.92 CTN shares (i.e. each CTNG allows you to buy 76.92 shares)
• Final maturity date 31 March 2020 of $100

Like AFIG, CTNG has allowed CTN to take on some leverage without the annoying standard margin loan features such as the lenders ability to just remove a stock from a margin lending list. There are some gearing covenants which should be noted - see page 17 of the prospectus. However CTNG is hardly an Alan Bond style debt-ears-pinned-back move: there are $26.5m CTNG on issue versus CTN gross assets of $206.6m (31 December). 

So, what's to like from an investors point of view? Firstly, the yield is okay which is currently 5.3% p.a. (remember this in context of an RBA rate of 2%). Secondly, the twist in the tail is the embedded optionality. You get exposure to upside in the CTN share price above $1.30. Remember, CTN is $1.08 and is trading at a discount to NTA. And you have four and a half years to achieve this - even a mediocre investment performance by CTN would get you there. The biggest point to like is a floor in the price of $100. It's unlikely CTN will blowup, so the more probably worst case scenario is a mediocre investment performance and you just get your $100 back in 2020. 

Imagine some basic scenarios of CTN being $1.50 in March 2020. Your CTNG shares are worth 76.92 *$1.50 = $115.38 each. Throw in the interest payments of $5.50 p.a. and assuming you paid the current price of $102.85, your pre-tax IRR is 7.6% p.a. If the CTN moves to $2 then your pre-tax IRR is 13.4% p.a.  

What's not to like? Well if you think interest rates will move up then fixed rate securities aren't so fun. And Cantango could hold the share price down by increasing dividends and/or issuing dilutive options. And obviously we don't know if the CTN share price will move above $1.30 in the future. 

Also, CTN is not a pure-play Listed Investment Company (LIC). Contango internalised management and the proceeds of the fund are invested in another Contango vehicle Contango Income Generator fund which itself has not yet listed. This is potentially confusing to investors and distracting for management. 

However I think the main point is that CTNG is ultimately a bearish trade. If you just buy CTN you immediately get a higher dividend yield 7.1% p.a. (plus some franking). And if the CTN share price moves up to $1.50 your pre-tax IRR is 13.4% and for $2 it is 19.5% p.a. So unless CTN moves south in a decent way, you are better off with CTN rather than CTNG. However, I've been through the GFC and the appeal of a floor in the price has decent appeal and obviously everyone has their own preferences.    

It's tough to get excited by CTNG. For me to buy CTNG I would need to see a bigger divergence between CTN and CTNG so there is more value in the security.  

Kristian 

Disclosure: no position in any of the above securities. 

Devine Ltd (DVN)

Well, I got this one completely and utterly wrong.

My reasons for buying DVN were a) big discount to NTA, b) improving/firming general property market, c) the first upgrade in years (the end of the profit downgrade cycle), c) the company putting itself up for sale (following major shareholder Leighton wanting to cash out) and d) plenty of good gossip that a firm bid would be made. 

I wrote this is in detail almost a year ago when the price was 93c. 

The company sales process has fallen over and the share price is now 75c. So that adds up to a decent loss and makes me a schmuck.

Two questions:

With hindsight, would I do the trade again? Probably. There were two decent catalysts being an earnings upgrade and the company putting itself up for sale. And plenty of value in the stock with a decent margin of safety - even taking the view the company would be sold for less than NTA.

Checkout the share price movements over the last year:

The price-action makes it pretty obvious the deal has been dead for some time and insiders have been well ahead of the market. What I would do differently is be attempting to reconcile why the share price kept sinking in the face of good news. These are tough situations to judge. As often as not, selling because of poor-price action can also be the wrong thing to do, however a stop-loss rule would have made the decision a lot easier.

The second question is what to do now. The fall-through of the sale process is the loss of a big catalyst, so to continue holding really requires some damn good reasoning.

DVN is cheap. NTA has actually pushed up a bit from $1.52 to $1.55 (31/12/14) so at 75c you get a whole bunch of property for half price. However: value alone is not a great reason to buy, and as noted in my last post (BOL) a value stock without a catalyst is a value trap. For example AV Jennings (AVJ) has been a long-term dog trading at a big discount to NTA for years. DVN's fundamentals have been improving, free cash flow has really pumped along over the last 12 months helping to get debt rapidly paid down and put a chunk of cash in the balance sheet, forecast profit looks pretty good (and is a good jump from current levels) so it's really quite eye opening to see the price where it is.

Anyway, I haven't made a decision as to what to do with DVN. The commitment I made to myself in starting this blog was not to sweep losses under the carpet - so I wanted to publicly discuss this trade. Please feel free to contact me if you have any views on DVN (or other stocks).    

Kristian 

Disclosure: own DVN 

Boom Logistics (BOL)

Value trap = value stock without a catalyst

BOL so far has been a perfect value trap, and if I didn't already appreciate what a value trap was, being a BOL investor has certainly has taught me that lesson. I apologise if anyone has followed me so far on this one and not made money. To recap on the original reason for buying (see some of the original posts here, here and here), the core idea was the huge gap between market cap and NTA. It is still monstrous: market cap $57m (12c/share) v Net Equity of  $227.5m*; a 75% discount. *Estimate based on the last management update of net debt $72.8m and gearing of 32%. Note that most of the intangibles have already been written down, so NTA is within ~1% of net equity. 

BOL has lots of exposure to mining which you don't need me to tell you is in a world of hurt. So BOL keeps the bad news flowing and has completely failed to initiate the stock buy-back and has instead kept on paying down debt, helped partly by the sale of surplus assets. 

This isn't news. The question is what to do: a company that will probably continue to experience an indefinite period of operational toughness thanks to mining, a slow Australian economy and unions sucking the life out of the business YET trades at a massive discount to NTA. 

We are missing a catalyst.

Management need to get their heads out of the sand and act. As noted in previous posts, if the NTA is anywhere near correct, then speeding up the asset sales process and simultaneously buying back it's own stock at a fraction of physical cost just has to be a smart move - it's called arbitrage! At the current prices, the arbitrage difference is 4 times, or sell something for a $1 and buy it back for 25c. Management have fobbed off the buy back until once the company has a more stable earnings outlook and current volatility in pricing pressures and activity levels have settled (page 5, half year report to 31 December). This business will always inherently be cyclical thanks being exposed to cyclical industries. But with an opportunity to buy-back the farm at 25% of the balance sheet value, who cares about stability or the earnings outlook - in fact if the earnings outlook is that bad then surely it makes even more sense to sell more assets at current prices? Surely there is plenty of risk to the downside to asset prices if the tough times continue? The argument to buy-back only gets stronger as debt levels continually reduce and management keep proving that either they can't run the business effectively or the macro headwinds are just too strong. Again, as noted in previous posts, as the market cap is so small, it won't take a massive buy back to move the price along.

Other than management, we can of course hope for a lucky break through a takeover/merger or a big uptick in the economy and crane hire business. That however we would be exactly that - a lucky break. Unfortunately I'm not the lucky type of guy. I don't know what other catalysts can get the price moving.

Shareholders have simply not been rewarded for their investment and therefore I believe it's now time for a change of management to shake things up. I hope the board agrees. 

Kristian

Disclosure: own BOL