Radiant Logistics

Company logo

Logistics – “The process of planning, implementing and controlling the efficient, effective flow and storage of goods, services and related information from point of origin to point of consumption for the purpose of conforming to customer requirements.”

Small and/or mid-sized businesses often do not have the ability to dedicate time or resources to extensively plan the shipment of goods from their factory to the myriad customers or geographies in their order books.   In these circumstances what is required is a cost effective way of outsourcing this task to a reliable company whose specialism is in making this logistical nightmare disappear.  Logistics is a mission critical service to a business: late delivery is as bad as no delivery and so manufacturers really do  place their reputation in the hands of their logistical providers.

The Business – Radiant Logistics (RLGT – $1.40)

Radiant Logistics is a micro-cap franchise non-asset based third party logistic (3PL) provider. RLGT negotiates with transportation providers who offer them favourable and priority rates due to their large purchasing power on behalf of clients.  The non-asset based part means that they limit their investments in facilities and transportation equipment. RLGT’s average shipment size is considerably larger than might be dealt with by FedEx or UPS.  RLGT provides a turnkey solution for the movement of goods customised to the customers’ needs and taking account of factors such as speed of delivery, special handling requirements and transportation mode.

RLGT’s operations involve obtaining and arranging transport of customers’ freight from point of origin to point of consumption/destination through their network of agent locations. These logistic solutions include inter alia domestic and international freight forwarding and door-to-door delivery services using a wide range of transportation modes (including air, ocean and truck).


RLGT was started with $5m of seed capital by CEO Bohn Crain.  Crain raised this capital by doing the rounds with a PowerPoint presentation and a good idea. Crain was actually approached by Private Equity firms to execute this plan but he walked away and did it solo as he didn’t feel they allowed him enough equity participation – he wanted the upside for himself. Although there is an element of organic growth through additional customers and servicing larger shares of existing customers’ logistical needs, the real growth story is one of industry consolidation via acquisition and expansion. RLGT is still of a size where adding small private companies to its network can have a significant impact. Yet it is still large enough to be achieve significant economies of scale and operational leverage. There is a decade long runway for multiplying the current revenue and earnings. The following factors (expanded upon later) below explain why this strategy could work:

  • The industry is extremely fragmented;
  • Increased profitability as a result of centralised functions reducing costs and new agents;
  • RLGT’s global reach   may enhance the breadth of offering and improve the pricing that agents can offer to existing client base and;
  • “The Gray Tail”

RLGT and how it works in practice:

Ryan O’Connor, at Above Average Odds, believes that

“There are essentially two businesses at work: a franchisor and a freight forwarding business.

For the franchisor, Radiant provides network support through industry leading freight logistics platforms, outsourced back office services (billings and collections, accounting, HR etc) and, most importantly, freight buying power. Franchisees keep 70% of their revenue, the rest goes to Radiant. Interestingly, Radiant withholds 6-8% of franchisees cut to account for bad debt. Franchisees are in a first lost position for bad debts.

Currently, the franchisor role is the biggest piece of what Radiant actually does (though they do have several corporate owned stations). According to CEO Bohn Crain, the corporate overhead is now at a size and operational standing where it can add significantly more franchisors and franchisees without adding any incremental overhead. New agents offer near 100% contribution margins.

Bohn describes Radiant’s freight forwarding business as “freight travel agents.” They buy blocks of transportation services from a wide array of truck, rail, air and shipping providers. They sell this block and provide logistics services to customers needing to ship goods. Domestically these services generate 35% gross margins. Internationally they generate 20% gross margins. The margin is a fixed percent of sales price. While changes in freight costs and shipping inputs indirectly affect margins, it is not a direct impact. Reviewing the business historically, the margins appear to be quite stable at 30%.

Customers generally do not have contracts. Bohn has likened the relationship to any other business service (lawyer, auditor etc) where you have a preferred provider based on a relationship and the customer has an ongoing understanding of what the cost of service is. While he could not quote retention rates off hand, he said they are very high and customer counts are growing (comparing their growth to the industry I buy this).”

RLGT has been acquiring non asset-based freight forwarding franchises. Over the coming years they expect to acquire the underlying franchisee businesses as well and this process has slowly begun. The growth of revenue comes from the addition of new franchisees to the platform and by increasing sales at their franchisees and at the growing number of corporate owned stores.  As RLGT  grows the network effects of the platform will become more evident and more attractive to new franchisees.  For example, when RLGT bought Airgroup they managed to grow sales by 100% in the first year- almost entirely on the back of the addition of new agents.

The Industry

3PL’s create their advantage by (i) pooling their customers’ orders to create scale and (ii) by eliminating “deadhead” (i.e finding more cargo to ship “back” on the return journey after the first delivery). This process is, in reality, very complicated due to differing (i) starting locations and (ii) timescales for delivery; but it vastly reduces the share of total transportation costs which  each manufacturer/customer must pay.  The 3PL pays the transporting company directly and then collects from the manufacturers (plus a brokering fee).  The industry standard income statement measures are reported as follows:

Revenue (re-sale price of transportation services to customers)

Cost of Transportation (the cost of purchasing the transportation from the carriers)

Net Revenues (the difference between the two from which RLGT then can deduct their costs)

Top-line growth is important but as the bulk purchasing power begins to kick in it will be net revenues that are key.

The Issue of Scale

It is ironic that the 3PL industry has great advantages to scale, and yet, it is one of the most fragmented which I have ever encountered.  The largest US based 3PL is CH Robinson (CHRW) which commands around 2% of the market and has a $10bn market cap.  The fragmentation is a reflection of the fragmented industry which they serve – there are more than 1.2m trucking companies (incredible statistic!) in the US and 90% of them operate with six or fewer trucks.

These big players have (i) much lower average fixed costs (IT/administration divided across higher sales) and (ii) wider distribution networks.  The foregoing enables them to: earn higher margins, higher ROE, generate cash and command earnings multiples of high-quality and high-growth businesses in at least 10x current year EV/EBITDA.

EBITDA is a good metric for this industry because (i) it approximates free cash flow to the firm and (ii) its most relevant for acquisitions because typically businesses in this sector will be asset light and therefore their depreciation and amortisation are insignificant.  If you take that premise and then include interest payments then this means that you can compare companies allowing for their differing capital structures.

The “industry pie” has been growing for the last 15 years at a compound growth rate of around 10%.

3PL Market growth

The main drivers for this growth rate were described by Torin Eastburn (who, incidentally, alerted me to this opportunity via his phenomenal body of work on 3PL’s)  founder at Monte Sol Capital:

The U.S. 3PL industry was more or less born out of the Motor Carrier Act of 1980. This act deregulated trucking, morphing it from a concentrated and somewhat cozy industry into an extremely fragmented and price-competitive one. The result was an explosion in the number of trucking carriers: there were less than 20,000 in 1980, but there are 1.2 million today. This explosion necessitated a middle man to help the customer navigate the multitude of new trucking options. 3PLs were born, many in the form of truck brokers.

Then came China. Economic initiatives implemented there in 1990 quickly turned the country into the global epicentre of low-cost manufacturing. This made almost all finished goods and components cheaper, but it also added great complexity to global supply chains. Sourcing goods and components, shipping them, storing them, and keeping track of them became something companies no longer wanted (or could) do on their own, so they started hiring 3PLs. In 2001 only 46% of Fortune 500 companies used 3PLs, but today about 85% do.

Finally came computers and the internet. Software has enabled great advances in the efficiency of logistics and distribution.”

harvard industry cycle

The above chart (taken from a Harvard Business Review article by Graeme Deans) demonstrates the lifecycle of industries post de-regulation.  The Y-axis is defined by the combined market share of the largest three companies although, unfortunately,  3PL’s don’t seem to merit a plotting, I think we can assume from what is laid out above (thousands of firms and the market leader with 2% share) that we are somewhere in the trough on the left hand side of the chart – entering, or in the middle of, the aggressive consolidation phase.

The consolidation game has allowed the mid-tier 3PLs to grow at astonishing rates, for example – ECHO’s 5-year revenue CAGR is 79%,  Coyote ( a similar-sized but private 3PL company) has grown 73% annually for the last five years and XPO, RLGT and AUTO  have all grown at about 30%. The growth rates of the big 3PLs pale in comparison.

5 year revenue cagr

Advantages to Scale

In the 3PL industry life gets better as you get bigger. The chart below is the most succinct way I can think of to illustrate the advantage of being big. It is borrowed from Torin Eastburn – again!

effect of scale on profitability

Clearly there is a virtuous circle once a firm achieves “scale”.  A large portion of 3PL corporate spending—payroll, financial & tax reporting, IT—can be rolled out across additional agents at minimal cost.  The purchasing power of your bulk orders increases and your networks stretch farther and wider than smaller competitors.

This chart on the progression of Expeditor’s Net Revenues and Operating Income over the last 12 years shows exactly how strong the correlation, between size and profitability, is.

net revenue to operating income

As Torin says… “The cost to hook up the one hundredth sales associate to your network is de minimis. So mature providers earn returns on equity in the 20-40% range while the smaller, younger 3PL companies like those at the bottom left of the chart above generate ROEs closer to the 10-15% range—still good, but not elite like the mature 3PLs.

The steepness of the 3PL margin curve also means that the larger a 3PL provider gets, the easier a time it has financing its growth.”

On a recent conference call Richard Lin at Three Arch asked “For EBITDA margin over Net Revenue you’re around 10.8%. What percentage do you think this company can get to with more scale?”

The CEO replied that Expeditors and CH Robinson run around the mid 30%’s on their EBITDA margin but much of this is the benefits of scale.  He said that there is no reason that Radiant shouldn’t be doing 15-18% over the next 18-24 months.  He later says that over 2 to 3 years they should certainly be hitting that level.

estimated size of logistics market

The Public/Private Arbitrage – an enormous runway for value creation

Occasionally, it is possible to come across an industry where there is a disconnect between (i) the multiple that a private buyer of a whole company might pay for $1 of earnings and (ii) what a buyer in the equity market might pay for that same $1 if it’s earned by a publicly listed entity.

If it is possible to buy that $1 earned by a private business for $5 and then turn around and sell it in the public market for $10 then you have the makings of a very attractive/accretive arbitrage.  This proposition becomes even more attractive if you consider that factoring in efficiencies, cost extraction and the benefits of scale can turn that $1 of earnings into, say, $1.20.

Now let’s take the above proposition – which already sounds pretty appealing –   and add to that that RLGT has a long list of, around, a thousand small operators where it can potentially rinse, wash and repeat this exact same roll-up strategy.  Furthermore, let’s throw in that the demographics and the technological changes in the industry are creating willing sellers with (this bit’s important) limited exit options.  And finally – let’s also throw into the mix that there are only a handful of realistic buyers and RLGT has some compelling advantages over all of them – this all sounds pretty good to me!

The small 3PLs are often run by entrepreneurial patriarchs who have spent their adult lives building their business, industry contacts, high-touch relationships and the transit network which they trade through.   In these businesses, succession planning is a real issue.  When the incumbent owner operators are looking for an exit they simply cannot command high prices because they themselves are often the largest asset of the firm.

EBITDA multiples for acquisitions of 3PLs/brokers with EBITDA in the single-digit millions have historically been for 3-6x EBITDA, with part of the consideration having been paid up-front and the remainder paid in the form of a multi-year earn-out.  Sometimes agents will seek to join RLGT for free because they see the inherent benefits of the larger shipping network and the advanced shared IT and back office functions.  In contrast to these very low acquisition costs, established mid-sized and large 3PLs generally trade for 10-15x EBITDA, making the opportunity for value creation through M&A enormous.  To put that in context – there are literally hundreds of these small outfits and they are struggling to compete in an increasingly high-tech global supply chain environment.  It is inevitable that these smaller outfits will find themselves with little bargaining power in the negotiating process – for many it is clearly  a case of be acquired or die.

In the scenario of “be acquired or die” RLGT may be particularly attractive to these small businesses as the acquirer relative to it’s mid-size peers or the large 3PLs.  Why? Well, Expeditors (EXPD) and CH Robinson have never used acquisitions and the <$5m EBITDA of the “Mom & Pop” operators isn’t enough to move the needle for them anyway.  I also think that culturally it may be too daunting for an entrepreneur to see his business fully integrated into a huge network like EXPD or CHRW – it would no longer be “theirs”.  RLGT is the only company that allows acquirees to get their “liquidity event” upon the sale but also to participate in the advantages of scale via earn-outs and (and this is crucial) through the purchase of further RLGT equity in the public markets, which is actively encouraged. This is vitally important in order to retain the acquired talent and keep them as motivated as they were when they were operating outside of the RLGT network.   The importance of this should not be overlooked, the case in point being that, the second biggest holder of the stock is a founder of a 3PL which was rolled up into Radiant.

Acquisition Strategy

The strategy is to roll up lots of small 3PL providers in a wave of natural consolidation at attractive multiples and to grow their earnings via the benefits of scale and by stripping out costs that can be centralised. Ryan O’Connor discusses a recent example of this:

“Radiant is just now at the size where their corporate overhead can eliminate significant redundancies with acquirees. Acquirees benefit from this through receiving comparatively high valuations versus the private market. For example, DBA was acquired for $12MM ($5.4MM cash, $2.4MM equity, $2.4MM seller note, and a $1.8 MM cost efficiency hurdle fee).

According to the CEO Bohn Crain, the business was operating at distressed levels and had generated $1MM in LTM EBITDA. Radiant identified $2MM in cost cuts that they could achieve right out of the gate, meaning that when absorbed the business would do $3MM in EBITDA. So in DBA’s eyes they were paid 12x depressed EBITDA. From Radiant’s perspective they paid 4x depressed EBITDA. Radiant is the only business out there that could have done this. (Of note, though he says 12x EBITDA isn’t a real number to him; Bohn admits he paid more than he wanted for DBA. He just really liked the network.)”

acquisition history

Adding New Agents to the Platform

The cheapest way for RLGT to grow is to poach or “onboard” agents who approach the company seeking to become an agent. They are incentivised to do this because it allows them to use the RLGT platform and benefit from their back office functionality and bargaining power. CEO Bohn Crain has said that it doesn’t cost anything to add an agent other than “maybe an airline ticket and dinner” but, importantly, once up and running that agent could add $250,000 of EBITDA. This fact is borne out by history and  the company has typically had 3-4 of these instances, a year – this is a nice benefit.

Company Owned Operations

The two largest expenses for RLGT are (i) agent commissions and (ii) personnel costs.  Agent commissions are calculated as the amount of net revenue that the individual owners of agent locations keep for themselves. Agent commissions, as a percentage of net revenues, have dropped from 74% to 61% from 2006 to 2012.

Personnel costs, by contrast, are the costs of RLGT running their company owned locations. Personnel costs have risen from around 9% to around 13%.  If RLGT can lower these operating costs relative to net revenues then its margins and profits will expand.

In fact, this is already happening in RLGT in practice in two separate ways: RLGT is:

(i) increasing the proportion and number of Company Owned Operations which don’t require agent commission payments and thus operate at higher margins (paying employees rather than owners). – (there is secular support for this trend as discussed in “The Gray Tail” below)

(ii) As RLGT’s network grows it becomes more desirable to independent agents and therefore RLGT has more bargaining power when it comes to negotiating the percentage cut they will take on transactions.

RLGT’s move to a more owner-operated location base will not happen overnight but it is  clearly a delineated part of the strategy and it is underway. The power of the mix shift can be seen when considering that relative to RLGT’s normalised EBITDA margin of 12%.  RLGT’s competitors, such as Expeditors, earn 30% EBITDA margins due to their locations all being company owned.

On February’s conference call Bohn confirmed that the focus is shifting towards “company conversions” from within the existing network as these require less time and effort but are still very EBITDA accretive. These are like the “onboards” above but with small initial fees.

In November 2012 RLGT acquired their Los Angeles based operating partner Marvir Logistics which was their first conversion of an agent station to a company owned store. This operation will be combined with their existing presence in Los Angeles leading to immediate cost savings. Going forward it will be used as a key example to future potential agents.

As the CEO said in the recent earnings release “Marvir was the first independent agent to join the Radiant family after our initial platform acquisition of Airgroup in 2006 and has consistently been one of the largest operating partners in our network. We are very proud to be able to support them in their transition and help them reach their individual goals. We believe the Marvir transaction showcases our broader opportunity to support other independent agent stations, both internal and external to our existing network. The Company’s flexible offering of an outright purchase, or the opportunity to participate in the Radiant Network as an independent owner with the option to sell at a later date – like Tom and Walter have done make Radiant an attractive partner.”

If I was a 70 year old minor 3PL owner I would be picking up the phone.

Rising Demand for Third Party Logistics

Increasingly companies of all sizes are outsourcing their logistics functions to experts like RLGT. Just in time production, coupled with complex supply chains have narrowed the margin for error on freight delivery. Furthermore companies do not want to encumber their balance sheet with a phalanx of expensive trucks to ship their goods when they can keep it clean with an expert, outsourced, pay as you use service.

Books like “The Long Tail” and “The World is Flat” have shown that geography and scale are becoming less relevant if you manufacture/produce a product that clients want. The cost of opening a “shop” is now as cheap as buying a website address or opening an eBay account. The infrastructure and logistical deficit that, say, “Duncan’s Fizzy Pop” has versus Coca-Cola can be somewhat mitigated by employing a 3PL to lower my average shipping costs.

Consolidation within the industry is forcing customers to consider the type of company they want to do business with and is forcing them to move up the food chain to 3PLs who can provide a one-stop shop.  Now some might view this is as a negative for RLGT as they are not the biggest 3PL– “no IT manager ever got fired for picking IBM.”

Technology Driving Change

Technology is also driving change within the industry and it is leading to the obsolescence of the older logistic intermediaries. 3PLs which previously relied on telephones and faxing orders around a few transport companies are being out-manoeuvred by the biggest and best operators (I believe this includes RLGT) which utilise automated software systems that which makes the entire process of allocating/tendering loads more cost effective  and the whole thing is conducted more efficiently.

In the face of these considerable challenges the old school operators (who have spent 20-30 years building up a network of valuable contacts and customer relationships) may soon see that the writing is on the wall and may look to exploit the value of their client book by being “rolled up” into a consolidator (perhaps RLGT?!).

Diversified Customer Base

As I alluded to earlier the nature of what is being shipped has changed over the last decade as show in Monte Sol’s chart below.

customer concentrations

The internet has turned supply chain management and logistics into an exact science where expediency and precision win the day. The use of 3PL’s by retailers has become very prominent and previously big customers like agriculture have seen a diminution to the significance of their contribution.

The diverse nature of the industries relying upon 3PL’s offers a buffer of protection to their revenue sources.  RLGT specifically has no single customer accounts for more than 5% of revenue and no single agency/office accounts for more than 12% of revenue. There is no key customer risk.

How Cyclical a Business is Radiant Logistics?

A logistics business cannot help but be tied fairly closely to GDP growth. Global trade has grown faster than GDP for 25 years, excluding years 2000, 2001, 2008 and 2009. Import and export activities as a percentage of GDP have been rising to nearly 25% in 2008, up from 13% over a decade ago. The CEO commented on the last call that he feels they are participating in the renaissance of American manufacturing to whatever extent that is happening.

As GDP slows people trade down in their freight preferences (slower deliveries) and the total volume of goods shipped will likely contract too. In economic downturns it seems that RLGT doesn’t lose customers, it loses volume per customer – this is important because it is clear that relationships are the stickiest part.

Thankfully, there are a few offsetting characteristics which mean that RLGT can continue to thrive in a weak economy. During recessions the excess capacity in some transport industries is exposed (think shipping/Baltic Dry Index in 2008), by retaining some of the benefit of reduced shipping costs RLGT can protect its margins. The real pressure is put on asset heavy shippers as they struggle to fill capacity that they are already paying for and which is depreciating rapidly.

A particular advantage to RLGT’s strategy is that acquisition led growth is not reliant upon the strength of the economy. A weak economy might actually allow RLGT to pick up more small players on depressed multiples of depressed EBITDA.  The probability of making a good acquisition at the bottom of the cycle is higher than at the top of the cycle.

Finally, as the economy recovers, goods are “expedited” to fill a rush of orders and premium/fast shipping is in high demand. The more time sensitive the order, the higher the margin RLGT can earn on it.


RLGT is a micro-cap with 2 sell-side analysts covering it. Furthermore it’s only been listed on the AMEX for a few months and has a free float of around $30m (most of which seems to be owned by SumZero members or RLGT agents!) – it is no surprise that this stock is unloved and mispriced.

The handful of people that do try to value RLGT are currently focused on a difficult economic environment and some digestion/legal issues with the last acquisition (which I expect will be mildly positively resolved but most likely a non event/distraction). (edit – this has subsequently been resolved and RLGT has been awarded damages of $600,000.) The market is totally ignoring the inherent operational leverage and fast growing revenue base.

revenue cagr

net revenue cagradjusted EBITDA

Current forecasts for top line revenue are around $339m for FY2013 (ends June 2013). The net revenue margin for 2012 was 28.5%. Extrapolating that into 2013 gets us Net Revenues of $96m. Based on what was said above about achievable EBITDA/net revenue margins being 15-18% let us assume a conservative 12.5% – half way between 2012 levels (10.7%) and the 15% target range.

$339m x 28.5% x 12.5% = $12m of FY2013 EBITDA

To convert this to Net Income we can assume $1.5m in interest payments and a 35% tax rate

$12m – $1.5m = $10.5 EBT

$10.5m x 0.65 = $6.8m Net Income

$6.8m/35m fully diluted shares outstanding = $0.194 per share.

7.5x P/E ratio on 2013 earnings – this is not a bad price for something that has such a strong record of growth and such a large opportunity set in front of it! It is interesting to note that Expeditors and CH Robinson both trade on 19x 2013 EPS despite the fact that as shown above in the Industry Consolidation section their growth rates are less than half of Radiant Logistics. At 15x 2013E Radiant Logistics is a $2.90 stock; at even 10x there is substantial upside.

Price to Net Revenues

One interesting experiment might be to look at Price/Net Revenues and make an adjustment for the margin difference between the two stocks.

Expeditors 2013 Net Revenues are estimated to be around $1.9bn.  Their current market cap is $8.1bn.  That makes a Price/Net Revenues of 4.3x – this is what you pay per dollar of net revenue.

RLGT achieved $84m of FY2012 Net Revenues and the market cap is currently $48m. RLGT is therefore on   a Price/Net Revenues of 0.6x.  This means that you are paying $0.60 for each $1.00 of current year Net Revenue.

Unfortunately the difference isn’t quite so stark because we need to make an adjustment for the – the EBITDA margins at Expeditors are clearly superior.   If EXPD make a 30% Margin and RLGT are only achieving 12% (because of scale and growth expense) then it only deserves to trade on 12/30 * EXPD’s Price to Net Revenue.

(12/30) * 4.3 = 1.7

1.7x $84m Net Revenue = $146m

$146m/35m shares outstanding = $4.17 per share

Looking at FY2014 (ends June 2014)

A conservative 10% revenue growth (relative to a 40% CAGR up to this point!) gets us to revenue of $373m.  Further EBITDA margin expansion to 15% is quite achievable on the larger revenue base.

$373m x 28.5% x 15% = $15.9m FY2014 EBITDA

To convert to net income we can assume $1.5m in interest payments (and a 35% tax rate again).

$15.9m – $1.5m = $14.4m EBT

$14.4m x 65% = $.9.36m

$9.36m/35m Fully Diluted Shares Outstanding = $0.267 FY2014 EPS

$1.50/$0.267 = 5.6x 2014E (with no consideration for the accretive buyback programme recently enacted).


Valuation Part 4 – Close your eyes and think BIG…..

Bohn Crain has grown Radiant Logistics from revenues of $26m in FY2006 to revenues of $297m in FY2012. In six years he has grown an idea into a listed company with $300m of sales;  when he speaks we should take his claims seriously.   Crain talks openly of growing the company to a $500m to $1bn market cap.

A key part of this will be expanding the number of locations and growing the revenue of existing locations.   As the revenue base expands it will be harder for the market to justify Radiant Logistics trading on a 5-6x EBITDA multiple whilst the “big players” trade on double that.   The shift in mix towards owner-operated locations and the resultant margin expansion will also play a very large part.

As wild and optimistic as this may seem let’s paint a blue-sky scenario of what could happen if Bohn Crain delivers as he intends to.

  • Let’s imagine that revenue grows at a 20% compound rate for the next 5 years (half of what it did in the last 5 years) – that takes us to $739m revenue by 2018.
  • Net Revenue Margin (Net Revenue/Gross Revenue) remains the same at around 30% which allows no benefit for increased purchasing power driving transportation costs lower.
  • The mix shift discussed earlier towards Company Operated Stores and network effects means that EBITDA/net revenue margins migrate to 20% from the current 11-12%. This is a large increase but remember the fully owner-operated store comps like Expeditors have a 30-35% margin!
  • As the scale of RLGT begins to resemble the big 3PLs then the multiple differential contracts and RLGT trades on 10x EV/EBITDA

$739 x 30% x 20% = $44m in FY 2018 EBITDA x 10 = $440m Enterprise Value

$440m – $30m in debt = $410m equity value

$410m/35m fully diluted shares outstanding = $11.71 per share

This seems ridiculous, an 8x return from today’s share price, but the assumptions are not totally unrealistic. Let us remember that with many hundreds of Mom & Pops generating $1-5m of EBITDA and willingly available at attractive multiples due to worries about succession planning and obsolescence we are not relying on robust growth to underpin our assumptions – the thrust of the industry’s evolution is in our favour.

If the 3m share buyback were to be executed in full the upside would be substantially enhanced.

$410m/32m fully diluted shares outstanding = $12.81

Offering a 915% return from my $1.40 entry price.

valuation table

“The Gray Tail”

Torin Eastburn again…..“The Motor Carrier Act, the 3PL industry’s version of the big bang, went into effect in 1980. If the average 3PL entrepreneur was 30 years old then, he or she is 62 now and thinking about retirement and succession. Many of the 3PL businesses that were started back then are still quite small, and without the “head guy”, they face uncertain futures. To cash out while also ensuring that the business lives on in some form, many of these entrepreneurs will have no choice but to sell to larger 3PLs, either for cash or for equity in the acquiring organization.”

Gray Tail

The CEO is acutely aware of the fact that RLGT is one of the few realistic options these “industry pioneers” have but rather than trying to screw them he seems intent on offering them a way out with their legacy intact and continued operational and financial participation -Win/Win!


Bohn Crain has worked in the freight industry for 20 years, and is assisted by an experienced exec team.   Bohn owns more than 30% of the equity of the company and has consistently added to his position in the open market – at prices above the current level.  Bohn takes an extremely modest salary of just $200k.  The second largest holder of the equity is Doug Tabor who is the single largest agent station holder – he has been instrumental in sourcing new deals and helping onboard new agents for RLGT.

Insiders own more than 40% of the company which is fantastic when it comes to ensuring they have it all on the line.  It does however mean that the free float is particularly limited!

Balance Sheet/Debt Position/Buybacks

RLGT’s credit revolver is $20m, maturing November 2013, and as of end of August there is $9.6m available.  The terms of credit flex between LIBOR +1.75% and LIBOR+3% depending on RLGT’s performance relative to financial covenants.

In December 2011 the company issued $10m of senior subordinated notes maturing Dec 2016 to Caltius Partners at a cost of 13.5%. This is clearly a very expensive form of capital and I hope that this doesn’t happen again!

In May 2012 the company filed a shelf registration to sell any combination of stock, preferred stock or debt totalling $75m.   Then, on 21st November the company announced a share buyback of up to 3 million shares (9% of shares in issue) from cash flow and the revolving credit facility.  A word of caution – it is possible that only 1m of shares can be repurchased before they would be breaching lending restrictions.


  • The CEO was involved in a previous company which exploded under a mountain of debt “Stonepath”.   Whilst I am not entirely familiar with the situation,  analysts I respect such as Torin and Ryan are quite confident that he is a more chastened executive as a result.
  • Should they need growth capital it may prove expensive as did the Caltius Partners’ notes in 2011 – 13.5% is not a sustainable WACC!
  • Related party transactions with Radiant Capital Partners a company owned 60/40 between the CEO and the company although this risk is largely ameliorated by his very large equity position in the company itself. (see Above Average Odds comments for in-depth discussion of this)
  • Deterioration of relationship with Independent Agents.   Just as they have poached agents from other 3PL networks there is a risk that someone else’s value proposition is more appealing/lucrative and as a consequence – agents may leave (I am not aware of any instance of this happening).
  • Aviation and Transportation Risks regarding terrorism and fuel costs.
  • Security concerns – they are responsible for valuable/sensitive cargo.
  • Cross-border laws – breaches are subject to fines – this can be a complex area.

CalFrac Well Services (CFW.TO) – Diversification, technological innovation and the unconventional resource revolution


As a contrarian investor I look for opportunities to identify companies whose likely future will be better than their perceived future. It’s that simple. In this light, pressure pumpers are key to the changing face of resource development. Despite this, because of some short term supply/demand dynamics in the industry, I believe the long term stream of cash flows which will accrue to owners of CalFrac Well Services (CFW) is currently being profoundly undervalued.

Calfrac Well Services Ltd is an owner-operated provider of specialized oilfield services in Canada, the United States, Russia, Mexico, Argentina and Colombia, including hydraulic fracturing, coiled tubing, cementing and other well stimulation services.

Calfrac was founded in 1999 by Ronald Mathison (Chairman) and Doug Ramsay (CEO) who remain major shareholders today. They are a top 10 global and top 5 North American player in well stimulation, fraccing and pressure pumping deriving more than 90% of revenue from this secular growth industry.

Market Capitalisation $1.0bn
Price $22.75
Book Value $16.50
Dividend Yield 4.4%
2013 P/E 6.5x
2013 P/CF 3.5x


Extracting Energy from Shale Rock & Horizontal Drilling

It is not easy to extract gas or oil from shale rock – it is tough and uncompromising! The rock traps the gas and oil so tightly that it has never been economically viable to extract. Over the last few years technology has developed which has allowed the rock to be cracked enough to release its valuable cargo.

Below is a video from The Weir Group website on the process of horizontal drilling and fracking. http://www.weir.co.uk/industries_served/oil__gas/the_fracking_process_explained.aspx

David Yarrow of Clareville Capital described the process of horizontal drilling and hydraulic fracturing as follows:

“Horizontal drilling So as to tap the thin layers of shale, wells are drilled vertically to intersect the shale formations – often at depths of 10,000 feet. The well is then deviated to achieve a horizontal wellbore within the shale formation. These horizontal wells can now travel up to 2 miles along the shale seam in parallel with the ground 2 miles above. Hydraulic fracturing The poor permeability of the shale is addressed by hydraulic fracturing. A “perforating” gun is fed down the bore and gives off a string of explosives that blow holes the width of a fine knitting needle 18 inches into the shale. Then comes the genesis of the SPM story. At least a dozen trucks with pumping equipment generate enough horsepower to blast a mixture of fine sand, water and lubricant chemicals into the bore. The sand blasts into the piercings in the shale and jams open crevices so that the gas can find its way into the bore. As much as 10 million gallons of water and 10 million pounds of sand can be pumped into a single well during the fracturing stage. It is a fluid intensive process….

The recovery rate in aggressive and unwelcome shale formations will depend less on skill and more on the power and pressure of your pumps. Furthermore the pumps are going to take a hell of a beating in an intensive programme of trying to smash the gas out of the shale. In this underground battle zone, horsepower, precision and durability are key variables. It is intuitively comfortable to contend that operators will not then compromise on the integrity of the pumps or the quality of the after service. After making the well, there would seem no point in cutting corners in well stimulation in a rock that doesn’t really want to “play ball”. Those that build wine cellars, don’t tend to fill them with too much Bulgarian red.”


Energy Independence in the US

“You can always count on Americans to do the right thing – after they’ve tried everything else.” Winston Churchill


“Energy independence is the best preparation America can make for the future.” President Ronald Reagan, 1982


“Our goal should be, in 10 year’s time, we are free of dependence on Middle Eastern oil. And we can do it. Now, when JFK said we’re going to the Moon in 10 years, nobody was sure how to do it, but we understood that, if the American people make a decision to do something, it gets done. So that would be priority number one.” President Barack Obama, 2008

The US drive for energy independence is ongoing. The Shale energy story is an exciting one because it offers light at the end of the tunnel to potentially hundreds of thousands of American citizens humbled by unemployment and impoverished by high oil prices.

Shale Oil offers highly attractive break-even levels estimated at around $50 per barrel, by both insiders and industry consultants, with increasing recovery rates driving significant growth in the industry. This healthy cushion between current spot of north of $100 and these breakevens gives a margin of safety to anyone planning projects of this type.

The US EIA predicts that Shale Oil production growth will be 12% per year out to 2035, a clear indication of the US appetite for self sufficiency. The International Energy Agency forecasts that growth in Shale Oil production in the US of 265% from 2010 to 2016.

The chart below demonstrates the scale of the boom we are currently experiencing, US shale gas production has increased by a factor of 12x of the last decade and now that focus is switching to Shale Oil due to the current pricing differential.

Horizontal wells require longer laterals, more frac stages/pumps and increases the service intensity – Halliburton have estimated that this means revenue per well could be 1.4x to 1.8x higher for the service companies than for that of a dry gas well.

Some estimates suggest that just the Bakken in North Dakota could be producing 1m barrels per day by 2020 which is circa 1% of global production from one US state. Some have suggested that the Bakken has more crude than Saudi with an estimate of 300 billion barrels of oil. The main reservoir occupies around 200,000 square miles deep underground.  Even today North Dakota produces more oil than Ecuador which is an OPEC member!

How much of the 300 billion barrels is actually accessible is dependent on the extent to which technology and expertise continue to advance. What was once impossible is now practiced widely. The recoverable percentage is likely to go up and the breakeven on the extraction may well fall. As an example, in 1995 the recovery rate was estimated at 0.1%, in 2008 it was estimated at 1.5% and now it is gravitating towards 3%.


Horizontal Drilling – The Game Changer?

Horizontal Drilling has been described by former BP CEO Tony Hayward as a “game changer” and by Sir Ian Wood, founder of The Wood Group, as “the most significant development in the industry in a generation”.

The dynamics of the industry are extremely attractive for CalFrac. There is growth on top of growth here. Increased expertise and advancements in technology have led to the fracking process becoming increasingly more intensive. More wells being drilled, lateral lengths increasing, greater horsepower requirements and increasing frac stages per well leads to higher operational intensity and of course higher revenue per well. This contributes to more wear and tear on equipment and increasing reliance on highly skilled operators at all points in the supply chain. Frac fleets are often operated 24/7 due to the shortages of skilled manpower and specialised equipment; downtime is a luxury that cannot be afforded and utilization rates are increasing. CalFrac’s annual report in 2011 claims 40% of the US frac spreads work 24 hours a day. Data from Halliburton shows that service intensity in 2010 was 7x greater than that in 2006 and doubles that of 2008 just 2 years earlier.

Car tyres have a pressure of around 30 pounds per square inch. The Weir Group pumps that CalFrac operate function at 15,000 pounds per square inch and therefore are require extreme care.

As Yarrow recalls in his report: “Steve Noon told me that he had seen a controlled blow out of a SPM pump in an empty field. One of the iron components which weighed the same as a small child, ended up 250 yards away. Sadly, every year there are deaths adjacent to the pumps in horizontal drilling – it is a tough old game.”

Perhaps this anecdotally hints at the rare mix of bravery, precision and skill demonstrated amongst the men who operate at the sharp end of the oil extraction business.

CalFrac has an established footprint in the world’s four largest pressure pumping markets. This has not come about by chance but instead by successfully implementing an aggressive organic growth plan since it came to the public markets in 2004.

CalFrac will be highly levered to a recovery in Natural Gas prices. A recovery in prices to around $5 per mmBtu will be encourage a lot more exploratory drilling and make a lot more projects economic which would encourage fraccing activity throughout North America.

Perceived Volatility

The market perceives that CFW must be a very volatile business with revenues fluctuating on the whim of E&P companies and their exploration budgets. This is wrong. Across it’s US and Canadian business CFW has around 66% of their frac spreads operating on some type of long term commitment contract with the rest subject to the vicissitudes of the spot market. Furthermore CFW’s client base consists of more than 220 oil and gas companies ranging from multi-nationals to independent operators. From the Q2 Earnings release, “the increasingly competitive business environment as competitors move equipment from dry gas to oil and liquids rich plays, the company does expect additional near term pricing pressure in this market. CalFrac believes that its strong contractual positioning will partially mitigate the impact of these competitive pressures.”

In 2009 when the US market was suffering the overseas businesses were proving resilient and cushioned the blow that the financial crisis was having on North American pumping. CalFrac have taken positive steps over the last few years to ensure its financial position is secure. The LT debt consists solely of $450m in 7.5% senior unsecured notes due in 2020 so they have plenty of breathing room on that facility.


Canadian Operations (50% of Revenue)

It is estimated that CFW has around 20-30% market share in Canada with its 400,000 horsepower.

CFW have signed long-term minimum commitment contracts with two of the most active operators in the WCSB. This benefits both parties because CFW get some revenue visibility and can plan for expansion whilst the operators get the benefit of better pricing and guaranteed access to pressure pumping capacity in what can still be a tight market at times. The downside for CFW is that they sometimes have to give a little on margin for this business.

One development which would be extremely bullish for the Canadian business segment would be the development of LNG export capacity over the next few years. This is politically difficult but would create many jobs and allow an arbitrage over overseas gas prices which remain much higher than North American ones.  The ability to export to profit from this would incentivise a lot of drilling/pumping/exploration.


US Operations (40% of revenue)

CalFrac entered the US market in 2003 and has grown aggressively since then expanding to nearly 500,000 horsepower and a market share in the region of 4-6%. The big three of Baker Hughes, Schlumberger and Haliburton have around 66% of the market between them.

CFW have executed long-term minimum commitment contracts with two large customers each in the Marcellus and the Bakken for the provision of two fracturing spreads. In Fayetteville CFW has two frac spreads in annual operation contracts.


Significant short-term headwinds and uncertainty

2012 was supposed to be a great year for the frac operators as they could capitalise on a tight market and extract economic rent. I saw 2012E estimates as high as $5.50 written in late 2011. These estimates have been savaged and now CFW will be lucky if it gets near $3.00 for the year. The de-rating of earnings estimates for FY12 is shown in red.

Analysts were extremely bullish heading into the year then demand wasn’t quite as strong as they had hoped, new pumping capacity flooded the market and input/labour costs rose putting pressure on margins. Add to this uncertainty over upstream budget cuts and it was a near perfect storm and that explains why the stock is down 20% YTD or 33% behind relative to the S&P 500.

Personally I think that CFW’s well respected management, entrenched local presence in key markets, battle hardened frac men and long standing reputation as a top operator are going to allow them to weather this storm until the supply/demand dynamics turn more favourable again.

The growing scale and complexity of well stimulation activity is forcing the frac companies to work more closely with their clients to deliver on projects – the relationship is becoming more like a partnership than a service provider. This should all add to the certainty of revenue and reduce the likelihood of these periods where either pumper or producer has all the bargaining power depending on where we are in the cycle.

I think the size of the addressable market is so big here that I am quite happy buying one of the best operators at a cheap valuation and riding out a few tough quarters as the industry fights a war of attrition. If they have maintained market share by 2016 I think the stock will be much, much higher than it is now.  This is a great business with savvy management and a massive macro tailwind which Mr Market has heavily discounted based on some teething pains. The hysteria over capacity issues needs to be put in some context – in 2010 CalFrac signed a long term contract in the Marcellus which had a payback period of approximately three years. Now maybe these kind of offers are no longer on the table but a 5-6 year payback period would be a big fall off and still represent an attractive use of capital.


Do Canadian Frac Operators have an advantage in the Bakken/Russia?

From what I have read it seems that the Bakken and Canada are two of the toughest places to attempt any horizontal drilling. The rock is tough and stubborn and the weather is often inclement with equipment requiring winterization and the men operating in extreme cold.
But Canadian and Dakotan operators are used to this, they have home field advantage. This familiarity with these adversities will surely give them credibility when negotiating with Russians for frac contracts in Western Siberia, a place known for its unforgiving climate.  Perhaps then CFW have an edge over their US focused peers in this regard.

Calfrac’s experience deploying state-of-the-art equipment, logistics, fraccing techniques and proprietary fluid technologies positions them well to push into new markets like Argentina and Colombia. I would also contend that they are big enough to be regarded as a safe bet (no-one ever got fired for choosing IBM) but small enough to convince upstream firms that they really care about these marginal contracts in emerging markets. For example, would Colombia move the needle for Schlumberger?


Coil-tubing as a low cost way of entering markets

In Latin America CFW have 3 frac spreads totalling 27,000 horsepower which is just a foothold. They are however building their reputation via 9 cementing crews and one coiled tubing crew. These are less capital intensive ways of entering than spending millions to deploy a fully kitted frac crew into a market where no-one knows your name.  I think this is a savvy way of turning overseas expansion into a “Heads, I win; Tails, I don’t lose very much” type proposition.

The LatAm segment has entered profitability now it has achieved operating scale, although Pemex’s budget cuts were enough to materially affect profitability in this region over the last 2 years. Run rate revenue is circa $100m and operating income is still just $6m.  Management commented on an increase in frac activity and average job size.

In the 2011 Annual Report Doug Ramsay says that despite having the third largest resource base in the world he estimates Argentina has just 200,000 horsepower of pumping equipment that is ill suited to unconventional work.

So at this particular moment, the third largest market in the world, for the most important advancement in the oil industry in a generation, produces just $6m in operating profit for for a company with 15% market share?! This is really a story in its infancy!


The Bear Case – A Falling Knife?

Overcapacity of hydraulic fracturing equipment in North America will continue for an extended period weighing on both revenue and margins. Flat rig counts support this belief.

Permanently lower natural gas prices due to supply glut.

High returns on capital are attracting competition – this is exasperated by relatively low barriers to entry. As a result, Calfrac will face lower market share with lower margins and higher competition.


Variant Perception

Unconventional well completion is not a commodity business, success depends on thorough science, sound judgement and continuously improving products and processes. For example, CalFrac believe that the chemistries/recipies for their proppants are an advantage over competitors and attempt to keep the blends proprietary.

The current disparity in energy prices sets the backdrop for an industrial resurgence in North America. This is not a short-term phenomenon; it is a very long-term opportunity. Things like the “Pickens plan” are likely to inspire a switch towards natural gas to capitalise on the energy equivalence. This will become a reinforcing opportunity as the acceleration of industrial development will require an increase in production of natural gas in North America.

I think it’s pretty easy to make a valuation case for CFW currently as the stock is cheap on a number of metrics; but what if the uncertainty of very low natural gas prices was removed? The sheer quantum of fraccing that would become economic at $5.00 natural gas would move utilization levels much higher across the industry.

Because of the USA’s natural endowment and this proliferating industry, energy intensive businesses will have a long-term economic advantage to being based North America. The size and scope of the untapped resources will enable significant amounts of capital to be invested, much of which we could expect to flow through the frac operators.

The bears focus on the rig count number stagnating, but this overlooks the other key variables. Meters drilled due to longer horizontal laterals. Total well depth, or ‘meterage’, has become a much more important indicator as a result of the increase in horizontal rigs. A greater number of fracturing stages and higher fracturing intensity along the laterals should lead to continued demand for pressure pumping even in a flat rig count environment.

The Growth of the US Energy Industry

Over 90% of new oil and gas wells in North America now require the use of hydraulic fracturing. Hydraulic fracturing costs make up 30% – 60% of the total well cost up from ~10% just 5 years ago.


The Global Opportunity

The US is at the cutting edge of the Shale Oil revolution but is crucial to understand that it does not have a monopoly on the resources. Many countries possess large estimated shale resources; China is believed to have 1,275 trillion cubic feet of gas, compared to the US with 872 trillion cubic feet, that’s 50% resource more in an economy that is currently still considerably smaller. The US is estimated to possess only around 15% of world recoverable shale energy reserves so this is a story in its infancy. Furthermore as technology improves the recovery rate will improve. Argentina, Australia, South Africa, Libya and Brazil also possess resources of a size which are large enough to provide the impetus for energy independence.

In Russia, CalFrac’s 45,000 horsepower are operating under 3x three year contracts and 3x one year contracts. The opportunity in Russia is a very large one but their use of oil technology runs about five years behind the west. Much of the CalFrac work there currently is about the recompletion of legacy oil wells which are becoming economic again.  At the moment the run rate revenue is circa $120m and $8m operating income.

Talk of short term oversupply of equipment in the US misses the wood for the trees; there is a real bottleneck of supply in the global energy arms race, Halliburton have commented that the US has 15% of global reserves but currently has about 85% of the global equipment base and it is still suffering from supply constraints in some areas.

As more countries seek to emulate the US potential for energy self-sufficiency, CalFrac has the global footprint and operating history to help these countries get their domestic industries up and running. CalFrac and its peers have the experience, expertise and horsepower to be the enabling factors between these countries and the monetization of their natural resource endowment.

I think these enormous reserves in foreign lands presents an exciting long term dynamic that is not reflected anywhere in the current CFW price.

One broker report I read on Weir dismissed the international opportunity out of hand seeing no impact on a 24 month horizon therefore excluding it from valuation completely. The market seems to be doing the same for CFW’s Russian and LatAm businesses – I think this is totally wrong and it could be a catalyst on good news.




Below is a chart showing the progress that CFW has made over the last 6 years and how the market has rewarded them for it. We have book value per share and total revenue in blue and brown growing at an impressive rate whilst the light blue coloured line shows the relentless de-rating of the P/B ratio moving from 5x to today’s 1.35x.

The next chart shows the secular de-rating of CalFrac on a price/sales and a price/cash flow basis. CFW now trades on 3.5x cash flow and 0.6x sales from previous highs of 25x and 5x respectively. These valuation metrics are down 80/90%!!

And finally below, the questionable but catch-all, EV/EBITDA which twice peaked at 16x and now sits at around 5x versus peers on 8x. These metrics all price CFW like it is a business in secular decline. I would hope that all of what I have covered above show that the reality is quite the opposite. On pure valuation grounds I think CFW could be a double, depending on how they execute in the next few years, perhaps a lot more.

CEO Doug Ramsay sums up my thoughts, “Although the timing and pace remain uncertain, the opportunity is immense.”


High Quality Management – High Insider Ownership

  • Experienced, shareholder friendly management team led by CEO Doug Ramsay and Chairman Ron Mathison.
  • Ramsay has over 25 years of industry experience. Mathison is a former investment banker.
  • Directors and Management own 26% of the company’s outstanding shares.



A recessionary environment in the US would of course be a big risk to a stock that is fairly cyclical and perceived to be highly cyclical. One might contend however that a US recession would actually strengthen the case for the energy independence mandate. CFW is highly geared to commodities and global growth and demonstrates a high beta; I am quite convinced that a market selloff would lead to short term price weakness.

Commodity price weakness – the current oil price is substantially above the breakevens for most projects however there is almost no doubt that some capex could be held back or projects deferred if prices fell. Management have stated that even at $80 oil there is a strong incentive to drill. 70% utilisation of the frac fleet is the point at which pricing power shifts from customers to the fraccers.

Regulation – France became the first country in the world to ban fracking and there are noises that this is possible elsewhere. This could of course be nearly catastrophic for CFW but as far as I am concerned the economic benefits of continued unconventional oil and gas industry far outweigh the benefits of pandering to a few environmental interest groups. I suspect that Capitol Hill agrees.

To quote David Yarrow again….

“Obama’s populist response to Deepwater Horizon is proof that there will be times in the battle between the environment and US energy independence, when the environment – briefly at least – comes out on top. However, since 2011, events in the Middle East have again caused America to obsess about its reliance on oil importation.

However, the Gulf of Mexico is not Pennsylvania – a state reeling from the decline of the coal industry and manufacturing generally. Nor is it Republican Texas where the oil lobby wins or North Dakota that could well do with a new industry employing tens of thousands of workers. The critical point surely is that the shale oil revolution is a huge boost for America and Americans. Environmental issues will not go away and there will be new legislation that curtails certain practices in, for instance, water disposal. However as with all hot potatoes, and this one is red hot, there will be no winner and loser, but a series of fudges and compromises.”

CalFrac uses the “12 Rules of Green” published by the US EPA as guiding principles for development of fluids.

Guar Pricing – Speciality chemical inputs can have a surprisingly disproportionate effect on margins and are, unfortunately, not easily substitutable. On the conference calls management have been keen to point out this problem and say that cost escalation provisions in the long term contracts mitigate this to some extent.



AirCastle Ltd: Niche Lending – What happens when your competitors disappear?

“A capitalist should have shot down the Wright Brothers during their historic “first in flight” moment.” Warren Buffett


Aircastle Limited (AYR) is a global company engaged in the acquisition leasing and trading of high-utility commercial or freight jet aircraft to passenger and cargo airlines. As measured by the value of their airplane portfolio they are a global top 10 player.

AYR was founded in 2004 by Fortress Hedge Funds and then IPO’d in 2006 at $23. AYR profits from the spread between their lease revenue minus their interest and operating costs and depreciation. Leases vary from 3-12 years and the lessee is responsible for maintenance, operating and insurance costs. All rental payments and deposits are paid in USD. The business model is very similar to a REIT for aircraft.

Key Metrics

Market Capitalisation $800m
Price $11.00
Book Value $20.00
Dividend Yield 5.5%
2013 P/E 5.5x


The Change of Industry Circumstance

On the demand side, Airlines are struggling to get finance because of their history of sketchy profitability (enormous understatement!), there is also a desire on their part to keep their balance sheets asset light and flexible and to minimise residual risk. Therefore leasing has some strategic advantages as it offers a far less committed way to attempt to fine-tune their capacity needs.

On the supply side many of AYR’s historic competitors are leaving the industry or being rendered uneconomic just as AirCastle is reaching an economies of scale inflection point. In sum, we may be entering a decade where demand grows nicely but the economics of the leasing business tilt towards a few selected incumbent suppliers.


Emerging Markets Opportunity

The democratisation of air travel has been one of the most amazing developments in the last few decades in the western world – it no longer retains its aura of glamour or luxury. This trend has been globalising over the last 10 years with rapid growth of total seat miles due to an emerging middle class, opening up of trade routes and the internationalisation of previously regional franchises.

As the chart below shows there have only been 3 years in the last 30 when global air traffic growth has been negative although it is clearly strong correlated to global GDP growth.

AirCastle is positioned to capitalise on this trend by being a key facilitator for the growth of the airline businesses in the world’s fastest growing but often capital starved economies. Crucially, for small start up airlines leasing is often the only option to get up and running.

A Sampling of AYR Emerging Market Customers
Airline Country Number Of Planes
South African Airlines South Africa 4
Hainan Airlines Co. China 9
SriLankan Airlines Sri Lanka 5
Airbridge Cargo Russia 2
GOL Brazil 7
Iberia Airlines Spain (Essentially a frontier economy at this point) 6


Who Can Provide the Capital to Meet Air Traffic Growth?

Airlines are notoriously bad businesses and no-one wants to provide them with capital. Because of this the operating lessor penetration of the global airplane base has grown from 0% in 1970 to 35% today and it will likely increase more as airlines stay asset light through both a desire to remain flexible and because banks won’t lend to them!

Pre financial crisis, AirCastle was at a permanent disadvantage, two of its biggest competitors had AAA parents (AIG and GE Capital) and used their balance sheets to borrow cheap and short – continuously rolling over the debt. This allowed them to either earn superior returns to AYR, or alternatively, to offer better lease terms to customers and still earn the same spread. Obviously, both parents encountered large problems and are no longer able to compete as effectively in this industry.



Increased Balance Sheet and Portfolio Flexibility

The risk for any leveraged company (and AYR certainly does have some leverage at $3.2bn of debt) is that lenders start to get nervous and call in their loans. AYR has done a great job here of insulating themselves from this risk by extending the term of their debt and by forging a strong relationship with the bond market by gradually switching some of their finance into unsecured bonds – raising around $1.2bn. This leaves the assets unencumbered and flexible and furthermore provides certainty on the financing that secured loans and bank finance don’t offer.

The table below demonstrates the power of the bond market access AirCastle have been coveting, freeing up the previously encumbered assets AND lowering the blended interest rate from 5.8% to 5.05%. A 75 basis point saving on interest costs on $3.175bn of debt is $23.8m a year or $0.33 per share (a big boost to a company that will earn around $1.50 this year).

As bond investors become more familiar with AirCastle and with the Aircraft Leasing business it is a distinct possibility that AYR will achieve investment grade status which would lower their effective interest rate further and allow them to finance their portfolio at tighter spreads.

As a result of the bond issuance the unencumbered proportion of total aircraft assets by value has effectively increased from 15% to 35%. This is key because it expands the menu of options available to management, they can be more opportunistic with purchases and sales as they no longer have the banks or creditors looking over their shoulders.


Weak Market = Opportunity for those with Firepower

The aviation bank market has contracted considerably. The European banks have almost disappeared from the market dropping from 36 in 2000 to just 10 today. The true willingness of these banks to extend credit could be in question too as the risk weighting on these kind of aviation deals does not make them attractive. The terms and pricing of their offers are no longer competitive which is why proven access to the bond markets for financing, which AirCastle demonstrably has, is a “moaty” quality.


Can AirCastle operate through a downturn?

As you can see below the utilisation rates of the portfolio has been pretty consistently in the high 90s from 2007 until 2012 through the GFC. Even better they did not have to drop the lease rates on the planes dramatically to maintain that utilisation – the yield stays pretty constant across the period. Customers went bankrupt and reneged on their leases; so AYR found new lessees within a number of weeks and delivered the planes to them.

Why does the yield and utilisation not fluctuate like you might expect? Well, these are long term contracts usually for 5-10 years, and it’s only in distressed situations that the keys are handed back.


From the 2011 Annual Report….

“For the full year 2011, Aircastle maintained a utilization level of approximately 99% and rental yield of about 14%. These strong results reflect our ability to effectively manage through several early lease terminations arising from the “Arab Spring.” We believe our consistent performance underscores Aircastle’s success developing one of the premier aircraft lease management platforms in the industry.”


Management Understand Capital Allocation

When I read the conference call transcripts I am delighted to see that Ron Wainshal (CEO) and Mike Inglese (CFO) consider the opportunity cost of the various options when it comes to capital allocation.

“Our mission isn’t to be the biggest aviation lessor, just to be the most profitable.”

“We will only seek to make incremental investments if they are accretive.”

Every dollar could be used to: pay down debt; free up encumbered assets; pay dividends; repurchase shares, or, used to make acquisitions in what they term is currently termed a “buyer’s market” for aeroplanes.

In 2012 and 13 the focus seems to be on expanding the fleet but as you can see below they have been shrinking the share count at a rate of around 10% a year for the last 2 years. When you consider the current Price to Book ratio of 0.5 or 0.6 you can get an idea of how accretive these buybacks are. They are attempting to balance this with the fact that scale derives a moat like advantage over competitors in this particular industry.


Dividend Policy

I think I would be less interested in AirCastle if I wasn’t being paid handsomely to wait with a yield of around 5.5%. The dividend is part of a flexible capital deployment program so there is no commitment to grow it. As far as I’m aware, it is a reflection of the opportunity set and profitability. However, I think it’s interesting to note that they have paid out $400m in dividends since the IPO in late 2006. This equates to half the current market cap returned to shareholders in 6 years and that’s off a smaller revenue base through a financial crisis!


Valuation – Bear Case

The most conservative way of valuing AYR would be liquidation value – AYR reports book value at near $20.00, Citi and Bank of America put “conservative” estimates of book value at $16 and $16.50 respectively. If we imagine that in a “scorched earth” scenario AYR had to find buyers for its fleet, or start selling the older planes for parts (“parting out”), then maybe they would be forced to sell for 0.6x “conservative” book which gets you $9.60 in return. That’s 15% downside from here before considering dividends. I can’t see this situation materialising when they don’t have a single debt maturity until 2017 and their customer base is so diversified. However it’s good to know – it provides our margin of safety.

Valuation – Base Case

There have been comparable transactions recently which we may find illustrative. Sumitomo Mitsui purchased the non-core RBS Aviation from the distressed UK bank. http://www.reuters.com/article/2012/01/17/us-rbsaviation-sumitomomitsui-idUSTRE80F1FI20120117

RBS sold its aircraft portfolio (206 owned aircraft with commitments to purchase a further 87 by 2015) to an SMFG led consortium for $7.3 billion. This not only removes a lingering overhang to sentiment in the industry, as everyone knew they were forced sellers, but at greater than 1x Book Value (versus AirCastle trading at 0.55 times) it’s likely to renew investor focus on aircraft leasing portfolios, particularly with visible growth and diversified customers. Additionally, the two bidders whose offers were rejected by RBS may re-emerge elsewhere as the rich and predictable cash flows of the lease streams obviously appealed to them.

Another example in Mitsubishi’s $1.3bn purchase of 70 plane Jackson Square Aviation a company with a similar total asset value as AYR of around $4bn but yet a 2011 net income just $25m relative to AYR’s $124m.


So a takeover bid at 1x book, or near $20.00, which in theory values the infrastructure, management expertise, project pipeline and operating franchise at zero offers investors an 81% return from here.

But how accurate is book value? Clearly Citi and BoA have different ideas from AirCastle management with a $4 per share difference in their numbers. I think we can take some comfort from the fact that management have managed to consistently sell planes for book value or more. From the 2011 Annual Report…

“Consistent with our focus on opportunistically divesting aircraft in order to unlock value for shareholders, we monetized a number of our investments in 2011. Specifically, we sold 13 aircraft for a total of $500 million in 2011, generating $39 million in gains. Since the Company’s formation, we have consistently demonstrated our aircraft sales capabilities. In total, we have now sold 30 aircraft, generating gross proceeds of more than $800 million and an aggregate unlevered return in excess of 14%”

On the March 14th 2012 conference call with the stock at $12.70, Mike Inglese said “I think the stock is undervalued period. By a lot!”

Pretty punchy from an exec on a public conference call!


Valuation – Bull Case

Another way would be to presume AirCastle remains a going concern and put a multiple on the 2013 earnings. Here I will quote the chap who drew my attention to the stock, Harris Kupperman at Adventures in Capitalism, because I have no quibble with his back of the envelope numbers.

In the first half of 2012, they earned $0.68 a share, but that also includes a $10 million impairment on an aircraft, add that back, and earnings come to around 80 cents a share for the first half before minor adjustments for tax. I should point out that this annualizes to $1.60 a share for the full year, but this is deceptive for two reasons. Firstly, there will be more planes in the second half of the year (those added in the first half that haven’t had the benefit of being in the portfolio at the beginning of the year and also new planes to be purchased in the third quarter), secondly, the company just refinanced their debt in a way that will save them approximately 50 cents a share each year. Add it all up, and I figure that run-rate earnings are better than $2.00 a share.”


So 5.5x 2013 earnings or an 18% earnings yield with a 5.5% dividend and a 45% discount to reported book value. At these kind of numbers not much has to go right for investors to make good money.

AYR has done a good job of growing book value over the last 6 years whilst continuing to grow its diversified revenue streams via long term lease contracts. We have discussed a few of the reasons why AYR is positioned to capitalise on the industry structure’s recent changes. Now since markets are forward looking you would expect that these qualities are starting to be priced into the stock via its rating; the chart below shows that this is quite clearly not the case. Revenue and book value have grown handsomely but the Price/Book ratio has been crushed from 3.0x post IPO to the current paltry rating of around 0.6x.

Now I don’t think 3x book is a reasonable valuation for the stock but that would be $60.00.

BoA ML estimate, using data from Ascend, that the aircraft leasing industry as a whole has been a profitable one over the last 30 years with annual returns of circa 10%, similar to that of a high yield/junk bond portfolio. Does that mean at 0.55x book I am buying an asset class due to give me 18% returns (10/0.55)?


The Depreciation/Inflation Hedge

We all know that current monetary policy is highly experimental and that there is the not insignificant potential we have a substantial inflationary accident in the next few years. In such an environment it will always be tangible assets that hold their value, and it will be real assets backed by nominal debt that benefit from a true wealth transfer.

Now obviously the planes that AirCastle owns depreciate at a rate which is up for debate but clearly quite significant. But if you think about it inflation is a force that will act contra to depreciation – a plane depreciating at 5% per annum in a 5% inflationary environment may not lose any $ value at all but the debt against it will be reduced by inflation + amortisation.


Why does the Opportunity Exist?

AirCastle is basically a sophisticated finance/investment vehicle selling to the most consistently unprofitable industry in the world. At a time where earnings stability is highly valued and non-cyclicality is prized I don’t think many investors can get over the “yuck” factor. This is an unloved business but it shouldn’t necessarily be so!

I don’t think there are many analysts out there considering whether AYR is gaining an advantage from its capital market access or how bank balance sheet deleveraging is having the unintended consequence of improving AYR’s economics.


What does the Portfolio and Lease Profile look like?

I want to highlight the diversification (across 67 Lessees and 36 countries) which helps to protect against any local disruptions like the Arab Spring or the Icelandic ash clouds. Another key attribute is the remaining lease term which blends to around 5 years across passenger and freighter for the portfolio as a whole.

The largest customer exposure, which I believe to be South Africa Airways, is less than 8% of book value and the top 10 customer accounts for around 45% of book value. Individual customers going bust is not going to materially affect this business, planes will be returned to AYR and then they can quickly be leased out again, sold off or parted out.

Management can also choose whether to tilt marginal purchases or sales towards the passenger or freight markets depending on which is more favourable. This is a unique position for AYR as no other listed leasing company is involved in the freight business which is around 1/3rd of AYR book value – another element of diversification. The freight business is attractive because the planes are that much more fungible with no need to refit them between leases the capex required is a bit lower. It is interesting to note that the global freighter fleet has an estimated average age of 25 years so much of this is nearing the end of its economic life.

One concern in the portfolio is that 24 planes or 8% of the portfolio by value rolls off lease in 2013 into what could be quite a weak market but the management team have options at their disposal to cope with this due to the unencumbered assets and unrestricted cash. In 2014 the number rolling off lease is 32 planes at 15% of book value.

The stock IPO’d at $23 and has basically done nothing but decline since. Unless you had the cojones to swing the bat in Q4 2008 or Q1 2009 then you are almost certainly underwater on the stock. No-one has anything but ill-will towards it!


Global Aircraft Market

The market is actually a lot more liquid than I imagined, although I’d guess it gets a lot less liquid at the points where everyone needs it to be! The benefit of this particular real asset is that you can easily fly a plane from Johannesburg to San Francisco if that’s where the buyers are, not so with property or some other major plant.
The aircraft market is not a homogenous one and there are big differences in the supply and demand dynamics for different vintages of planes, varying manufacturers and between narrow and wide bodied models. I find it interesting that a few years ago when people talked about AirCastle they emphasised how they operated with new planes. Today management talk about the highest ROE opportunities being available in mid-age, in production aircraft in the secondary market – this demonstrates a flexibility and open-mindedness to go where they think they can get the best value to build their portfolio. Specifically, they have said that buying new planes can be quite capital intensive in that buyers have to place large deposits which ties up capital and worse commits to a large capital expenditure several years out into the murky economic mid-distance.

Some competitors in the industry only source planes direct from OEMs like Boeing or Airbus. AirCastle takes a different approach, one that I think gives them an edge; they will buy from OEMs, the secondary market, airlines, “sale and leaseback”, other leasing companies or anywhere else there is a deal to be done. Mike Inglese says that their portfolio has been sourced from 70 different counterparties! Now that is bargaining power.


Fortress Funds Stake

AirCastle was spun out of Fortress in 2006 and they have been slowly exiting the business ever since. They completed their exit in August 2012 with a final sale of 2.5m shares which were purchased by AirCastle and cancelled as part of their buyback. This obviously removes the overhang of a consistent and very large seller from the stock which can only be good news.


Insider Ownership/Management Incentivisation

Between them the top men at the firm own around 2% of the equity.

  • CEO Ron Wainshal owns 603,784 shares worth $6.6m.
  • CFO Michael Inglese owns 268,151 shares worth $3m.
  • Chairman Peter Uberroth owns 259,367 shares worth $3m.
  • General Counsel David Walton owns 243,072 worth $2.6m.

Last year CEO Ron Wainshal received $600,000 in basic comp and total comp of $2.5m which seems pretty reasonable relative to the size of the company. He seems to have a pretty solid CV being educated at Wharton, doing an MBA at Chicago then heading up GE’s aviation finance business before taking AYR public. Here are two useful videos of him in action.




Michael Inglese is a mechanical engineer by training, a CFA Charterholder and did his MBA at Rutgers.


  • Aircraft Re-sale values
  • Larger players price uneconomically to squeeze out competitors.
  • Next generation planes devaluing existing portfolio
  • Freight Market exposure – 33% of business
  • Investors rejecting leveraged businesses
  • High oil prices
  • Deflation
  • Global GDP slowdown

Kelpie Capital – An Update

To those who have been wondering what has happened to the blog over the last few months,  and remarkably there have actually been a few emails of concern, I thought I owed you all an explanation.

I am soon to start work at a new firm and due to my desire to maximise this opportunity I fear I will no longer be able to devote as much time to writing. I will still post occasionally if I have something that I believe is particularly worth saying however the frequency may drop to a quarterly comment on the portfolio/macro and maybe the odd stock idea if I have one.

Personal Dealing rules at my new employer also mean that I will have to trade substantially less and therefore I will be outsourcing much of my portfolio to fund managers and maintaining a few key long term holdings.  I have attached my remodelled portfolio below.

I will of course be staying on top of developments at the individual companies and therefore am more than happy to discuss with any interested parties.

Kelpie Capital July Factsheet – Value Will Out



Ouch!! That’s what this month felt like, particularly on the last day when the market enjoyed a face-melting rally into the quarter end with the Aussie Dollar, Euro and S&P moving very strongly higher and therefore against me.

The problem this month is that basically, everything went wrong. Kelpie was down 1% relative to the FTSE All Share which was up 3%. The largest holdings in the portfolio did poorly;

  • Third Point Offshore down 3%
  • Energold down 10%,
  • Zicom Group down 12%
  • Aberdeen International down 12%
  • Sandstorm Metals & Energy down 21%

Pretty tough in a rising market! The hedge book took some serious pain costing the portfolio several percentage points.

The only strong performer in the portfolio was Yukon Nevada Gold, up 13%, which made several major announcements particularly drawing a conclusion to their “turnaround” and announcing that they are up and running as a fully producing gold miner on track to achieve 150,000 ounces for the year. Should they meet this target the stock is very cheap on all metrics, they are a possible takeover target in the near future.

The underperformance of the portfolio is in my opinion due to many of the positions being “deep value” in a time where the market has been rewarding momentum and quality at any price and ignoring the cheaper segments of the market. The charts below from Cannacord Genuity demonstrate the wide gulf in factor performance.


Below we can see the quarterly performance of value relative to the market. This is demonstrably one of the longest and deepest periods of value underperformance we have experienced. What can be seen in August 03 and Feb 09 is that these periods were ended by very strong rallies where the market re-assessed the sustainability of these ultra cheap stocks and rewarded them with higher, more realistic valuations. It is my contention, and that of the analysts who put together the data, that we are due another one of these periods of outperformance soon.


Regular readers of the blog will probably know that there is a vast array of academic research on the long term outperformance of value factors but for those who don’t or those looking for a quick refresher, I recommend the following from Eyqyuem Investment Management.



The UK Economy & Housing – Last Post on the Bugle – The Bear Case

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us, we were all going direct to Heaven, we were all going direct the other way.” Charles Dickens in 1859 “A Tale of Two Cities”

“Will the last person to leave Britain please turn out the lights. The Sun Newspaper, 1992 Election

“Britain’s economy is a must avoid….Gilts are resting on a bed of nitroglycerine” Bill Gross – “Mr Bond Market”

“Much has been written about panics and manias… but one thing is certain that at particular times a great deal of stupid people have a great deal of stupid money.” Walter Bagehot, ‘Essay on Edward Gibbon’


In this post I am going to venture into deep waters, discussing several of the macroeconomic headwinds facing the UK and ultimately why I think this is a very large negative for two assets I am trying desperately to limit my exposure to; the Pound Sterling and UK Housing. I will be testing the bounds of my limited circle of competence here as I am not a trained economist but hopefully for everyone’s sake I’ll be able to keep it simple and thankfully many of my sources have already done the hard work!


The UK Economy

The 2000s were a decade of growth for the UK, but that growth was an illusion. It was not borne out of productivity gains or of diligent savings but instead out of rising debt levels. Our seeming prosperity was, and remains, false.

From 1996 to 2010 exports and investments as a share of GDP declined whilst government consumption grew. The UK economy stopped selling things abroad, stymied private sector investment and instead focused on the expansion of its own government sector. As you can see below Public Spending as a percentage of GDP moved up from a trough in 1999 of 37% to today’s level of 46%.

From 1999 to 2009 public spending grew by 53% and public debt rose 73% (before including exceptional costs like the bank bailouts), despite all this spending, an effective stimulus or boost to growth, Real GDP grew only 16%. A painful example of the inefficiency inherent in government directed spending.

The growth that the UK has had over the last 10-15 years has been heavily reliant upon the extension of credit at every level of the economy; household, corporate, financial and government.

If you combine public and private borrowing, the UK has since 2003 borrowed an annual average of 11.2% of GDP, a clearly unsustainable amount. When the government deficit jumped from 2.4% to 11.2% between 2008 and 2009 all the government was doing was filling the void by replacing the private demand for borrowing which had been crushed by the global financial crisis.


Swimming in Debt

The chart below put together by Morgan Stanley serves to highlight the scale of the problem. The entire developed world is mired in debt but we really seem to be leading the pack, partly as a result of our banks failed attempts to take-over the world in the middle of the last decade. As a percentage of GDP our financial sector exposure is vast compared to other nations, even the apparently banking centric Swiss.



“Households took on rising levels of mortgage debt to buy increasingly expensive housing, while by 2008 the debt of nonfinancial companies reached 110 per cent of GDP. Within the financial sector, the accumulation of debt was even greater. By 2007, the UK financial system had become the most highly leveraged of any major economy…” (UK Budget Report, 2011)


Reliance On Ex-Growth Industries or the Public Sector

“Three of the eight largest sectors of the economy – real estate, construction and financial services – have enjoyed huge growth fuelled overwhelmingly by private borrowings. These three sectors alone account for 39% of economic output.

Another three of the ‘big eight’ sectors (accounting for a further 19%) are health, education, and public administration and defence, each of which has grown as public spending has ballooned.” Dr Tim Morgan

In my opinion there are still way too many financial sector jobs. The financial sector not only employs around 1.1m UK workers but they are often some of the best paid and the sector contributes massively to the UK tax take at around 12% of total tax revenue (PWC 2010 report) relative to their being around 5% of the workforce. The sector is shrinking inexorably but at a very slow pace, I see substantial downside risks to property and employment prospects in finance hubs like Edinburgh and London. However, the UK economy as a whole is highly geared to FIRE (Finance, Insurance and Real Estate) jobs so this shrinkage does not bode well.

The chart below shows the extent of the rebalancing on the UK economy that has taken place over the last 20 years with the “FIRE” sectors stealing share from the traditional industries.


Austerity is going to be a struggle given the current backdrop, the economy is already in recession whilst Europe implodes and the US slows dramatically. There is a comparison with Spain which also made commitments to harsh fiscal tightening to maintain the confidence of the bond market. The markets have not responded favourably, punishing the Spanish sovereign yield because they realise that the banks are heavily burdened with housing market losses which will eventually have to be socialised onto the sovereign balance sheet.


How does Financial Repression impact the UK?

“Financial repression includes directed lending to the government by captive domestic audiences (such as pension funds or domestic banks), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks, either explicitly through public ownership of some banks or through heavy ‘moral suasion’.

Financial repression is also sometimes associated with relatively high reserve requirements (or liquidity requirements), securities transaction taxes, prohibition of gold purchases (as in the United States from 1933 to 1974), or the placement of significant amounts of government debt that is non-marketable. A large presence of state-owned or state intervened banks is also common in financially repressed economies. In the current policy discussion, financial repression issues come under the broad umbrella of “macroprudential regulation”, which refers to government efforts to ensure the health of an entire financial system.” Carmen Reinhart


Regulatory changes like Basel require increased capital for non sovereign assets. The effect seems to be that in these times of extremely scarce capital banks are forced to own UK gilts as these are afforded a zero-risk weighting and therefore improve capital adequacy. The interlinkages between banks and sovereigns increase whilst the return on assets for banks is ground down by these low yielding holdings.


Price Discovery

House prices are interesting to me because price discovery is so slow to happen.

If people selling their house aren’t offered what they believe their house is “worth” they just don’t sell and therefore realised prices are always slightly better than the price at which you could sell on any short(ish) time horizon. Because there is no daily quote on property, there is also no volatility which makes property owners feel much more secure than they should. Your house is not subject to a constant bid like the stocks in your portfolio are. You are also not leveraged 10x on your stock portfolio like you might be on your house – something worth thinking about!


A Global House Price Bubble

As the chart below demonstrates the problem of a housing bubble was truly global, however it also shows that in the post bubble world the German and UK markets have not suffered anything like the declines that the other major markets have.

One might argue that part of this is capital flight from the European periphery nations flowing into the closest safe havens. If that were the case then hopefully my analysis above suggests that the UK’s safe haven status is misplaced and furthermore one might consider how permanent that capital is – what happens if the Greek shipping magnates decide in a few years that it’s to repatriate their wealth? Do you know many people who can afford a £8m two bedroom apartment in SW1? If so, do please point them in my direction.


Housing in the UK takes up a world leadingly disproportionate share of our income. Now an Englishman’s home is his castle but this has always been thus so why has the multiple of disposable income doubled since the 30s or 50s when I’m sure our predecessors were just as house proud?

“Comparing a typical dwelling price with per capita personal disposable income. Such a comparison shows a significant mean-reverting tendency) for real estate prices over time for most countries (the UK appears to be an exception here). It provides some important evidence that the US market is at a very low value in relation to income levels (also this is true for Germany and Portugal).”  Julian Callow, Barclays Capital


House Price to Earnings Ratio

The house price bubble in the 1970s in the UK was the result of 30% YoY increases but houses still only topped out at 3.8x average income, falling to 2.8x by the end of the mid 70’s. Today real wages are stagnant to declining and the price/income ratio remains elevated at 5x having peaked at 6.5x.

Now clearly there are only two ways for this ratio to mean revert – a sustained increase in wages so that we grow into housing affordability or alternatively a downward adjustment in house prices. Which seems more likely in a recessionary, over-indebted, 8% unemployment economy; a wages boom or a house price fall?




Repossessions – An Inventory Problem

Property market bulls point out that mortgage arrears and house repossessions have peaked at much lower levels than during the crash of the early 1990s.

(Source: FSA Dec 2011 Mortgage Report)


Repossessions and arrears have been less pronounced during this crisis because the economic crash was so much worse than the 1990s downturn. Because UK banks have been in such a fragile state, “extend and pretend” or “ever-greening” have been the tactics du jour. The government and mortgage lenders have gone to huge lengths to stop any tidal wave of repossessions.

According to the FSA, 5-8% of all mortgages are subject to some form of forbearance. This might mean moving to an interest-only mortgage, reducing your monthly payments, taking payment holidays or increasing the term of your mortgage. All of these steps help the borrower stay current and help the bank pretend they don’t own an impaired loan.

These clearly distressed but currently propped up mortgages aren’t included in arrears statistics and so the headline statistics.

Analysts at the FSA examined the payment patterns of these mortgages which are in arrears. Their report showed payments received as a percentage of normal expected payments due were down to 58.3% of the contractual amount.

Around 8.5% of mortgage borrowers in northern regions were in negative equity, where the loan amount exceeds the property value, in Q4 2011, compared with 3.3% in the south. Ratings agency S&P said that borrowers in the north were 30% more likely to be behind in mortgage payments than homeowners in the south.


Interest Only Mortgages

The chart below shows that in 2007 three quarters of interest-only loans taken out had no repayment plan backing them. This is nothing more than a call option on rising house prices. These interest only products just did not exist prior to the housing bubble.

Both parties to the loan are implicitly assuming that the house will at some point be sold for a higher price to pay off the principal. This is Hyman Minsky’s Ponzi finance in action.


MoneyWeek says “These mortgages are a big problem for lenders. They account for 36% of all mortgages outstanding (43% if you include buy-to-let mortgages). During the next ten years, 1.5 million interest-only mortgages with a value of £120bn (10% of all outstanding mortgages) are due to be repaid. How?

Who knows? Some will be backed by sensible repayment plans, but we wouldn’t be surprised if many have to be extended, putting further stress on lenders and borrowers….


The problem with the UK is that the housing market and the banks are two sides of the same coin. If the housing market falls to sensible levels of affordability, then the banks will be in trouble.”

Government policy has been targeted at protecting the banks and not requiring them to realise losses on housing related loans or securities. Because of this the housing market is taking longer to correct. The problem is that precedent suggests this may not work, Japanese banks were allowed to extend and pretend but it turned them into zombie institutions still struggling with the bubble hangover twenty years later. The housing market has been held up by cheap money and lax policy. For reference the Japanese property market is down around 80% since their peak.



Unwilling Lenders – The Banks

 “Ongoing economic uncertainties and high unemployment will likely cause many consumers to postpone moving home or buying for the first time, depressing demand for new mortgage loans. On the supply side, unsecured bank debt has fallen increasingly out of favour with investors, and lenders’ pursuit of secured funding alternatives – in the form of RMBS and covered bonds – has triggered a relative renaissance in these sectors.

But the costs of all types of funding remain high, and combined with tougher regulatory capital requirements, this may incentivise many lenders to curb lending or even shrink their balance sheets.” Andrew South,  Standard & Poor


If we pretend that the chap above doesn’t work for a ratings agency, his points are quite credible. Banks are looking to quietly and gradually offload their commercial and residential inventory in the hope they don’t flood the market and collapse prices, however they are cumulatively a huge weight of supply which will cap prices for years to come. We have a Mexican Standoff where no banks want to liquidate as it will damage prices and they would rather extend and pretend. However, each bank wants to be the first to liquidate because it knows the liquidations will force prices lower.

With unemployment rising and home values falling, lenders are less willing to provide new credit or refinance existing loans. Last year, £141bn of mortgages were originated compared in the U.K. with £363bn in 2007, according to the Council of Mortgage Lenders.

This all matters of course because without the extension of loans there is no-one to buy property. Rental yields are not yet attractive enough to provide compelling unlevered returns and the average family or FTB must get a mortgage to participate. In a deleveraging balance sheet recession world where financial repression is part of the policy toolkit it is completely rational that banks take the proceeds of loans that are repaid and roll that money into government bonds rather than their mortgage book. This will improve their capital base and risk weighted assets. There is however a fallacy of composition in that what is right for one bank to do becomes a systemic issue if all banks act the same way.

The growth of credit extended to the Private Sector is intuitively a very strong predictor of the changes in house prices in the UK.


Extreme Sensitivity to Interest Rates

Regulators are requiring banks to strengthen their balance sheets and make greater provisions against loans. The effect of this is a creep higher in all funding rates but particularly on standard variable rates which comprise almost 70% of outstanding mortgages in the country.

Low rates have masked the extent of the UK’s problems as they have forestalled consumer deleveraging. Lower rates have postponed and prolonged the emergence of mortgage and consumer loan delinquencies as they remain serviceable and current.

Fixed rate mortgages now equate to only 30% of the mortgage market as banks have shifted the risk of changes in interest rates onto the borrower via variable rates or “trackers”. The average Standard Variable Rate is 75bps higher than the average 2 year fixed mortgage. Using the average outstanding loan value this equates to an increase of £900 per year or almost 25% of UK average real disposable income.

The risk here is huge given the already stretched households.


More worryingly, the SVR spread over base has jumped to 300bps and creeping higher from a pre-crisis average of around 150bps.



The great thing about demographics is how predictable they are. We can say with near certainty that we know now how many 40 year olds there will be in 10 years time looking to move from their first home to their main family residence. Unfortunately the demographic pyramid tells us the answer is – quite a lot less than we might need. Now demographics are not destiny but without a major change in immigration policy they allow us a glance at the secular quantum of buyers and sellers in the future.

As the UK ages the demand for housing will decline, the velocity of transactions will decrease as people do most of their moving when they are younger, the under 25s move twice as often as the over 50’s. The eldest segments of the population also require fewer square feet per person than families do. Furthermore, older people are less capable or willing on average of bearing the debt burden of a large mortgage and are unlikely to lever up to buy a house. Although the UK’s demographic time-bomb is not as bad as some other countries like Japan’s or China’s it is considerably worse than the US’s young, dynamic and constantly evolving population. Rather than a middle age spread one would desire a pyramid shape to the chart below.


For each person that moves back into their parental home, or each elderly person that moves in with their children, another unit of excess inventory is created. Despite current record low interest rates most young couples cannot afford the average house – the most logical way for this re-adjust is with lower prices. The average age for a first time buyer in the UK is 35 years old; compared to 31 in the United States. Given the cultural similarities it is fair to assume much of this differential is down to affordability.

Home ownership is waning due to unemployment, inability to meet mortgage standards and a general disdain that is beginning to take root for owning an asset which is no longer guaranteed to appreciate. The fact it’s no longer a certainty to make you rich, a huge mindset shift from a few years ago, may make young people question if home ownership is worth the hassle – rent or stay with your parents instead. A secular shift to a realisation that houses are liabilities and not assets is perhaps afoot.


Unhealthy Growth – Rising Inequality

The gap between rich and poor is greater in the UK today than at any stage in the last 40 years. It is wider in the UK than in three quarters of OECD countries.


The Currency

No-one needs to own Sterling. Our fiscal largesse and austerity mirage would suggest that we have the benefit of being a reserve currency or a global trade currency – we do not.
The currency market will eventually reflect the reality that most of the fiscal austerity of the Conservative government is an elaborate ruse with government spending today £22bn higher than it was in 2008 and only down 1% or so on last year. Given the squanderous starting point this is hardly drachonian.

I believe sterling has benefited from being a comparative safe haven relative to the Euro over the last 24 months. Unfortunately, I think we have more in common with the Italians or Spanish than we do with the Germans.


I believe that we don’t just have an overvalued property market in the UK but that we are also facing many structural, societal and financial problems which does not justify the current premium placed on home ownership that assumes it is a productive asset rather than a liability in which we make a home.

The UK has serious problems with those that will become the property buyers of the next two decades. There is excessive youth unemployment, an oversupply of graduates possessing a skills deficit for real world jobs, an all pervasive entitlement culture and an intergenerational rift where parents appear to have spent their children’s inheritance and priced them out of their future.

Many graduates have been led to believe that because they possess a degree they have a god given right to highly paid, highly engaging employment in the industry of their choice but alas we do not have need for 25,000 Photography graduates each year or the thousands of degrees in Forensics driven by a generation brought up on CSI Miami. Not every graduate in “International Business Studies” is going to end up working as Richard Bransons right hand man.

Ultimately, the generation under 30s seems incapable of affording to buy their parents house having struggled through the Great Recession are stymied with patchy work experience and often substantial student debt that must be addressed before home ownership or saving even considered. A further 5-10 years of painful deleveraging and scarce growth is not going to help ease these painful adjustments to a harsher reality of lowered expectations and bruised egos.

If you have a plan to sell your house then I think you should do it pretty quickly (I sold an investment property last year) and if you are considering buying then you should perhaps consider the timing or whether you buying for profit or as a home.

It wouldn’t surprise me at all to see house prices at the same level they are today in 5-10 years time, the greater question will be whether they merely stagnate or whether we see a fall of anywhere up to 40% allowing the market to clear and buyers to swoop in.


Prozac Nation

  • Britain ranks 28th in the world for overall quality of its education system – behind Romania and Costa Rica – despite a doubling of spending since 2000.
  • Only 55 per cent of young people get a C or better in GCSE English.
  • The number of prescriptions written by NHS Doctors has risen 300% since 1997
  • 2 million Brits regularly rely on prescription drugs to have sex.
  • Britain ranks 89th in terms of regulatory burdens on business – behind Zambia, Saudi Arabia and Egypt.
  • Public spending on Advanced Technologies relative to GDP puts us behind Angola and Rwanda
  • The scale of our intractable tax system ranks 95th in the world behind Zimbabwe and Guatemala.
  • 1.8m households (7% of total) are currently on the waiting list for government housing.
  • www.emptyhomes.com estimates that in 2011 there were 930,000 empty homes across the UK.


Further Reading:


























Third Point Offshore (TPOG.L) – An “Alpha Master” at a Discount



Price –  930p

NAV – 1166p

Discount to NAV – 20%

Third Point is the biggest holding in my portfolio because I believe it gives me exposure to one of the greatest investors in the world at a substantial discount to the value of his portfolio. Better still, I think his macro aware, event driven, value oriented process is one that will hopefully thrive in a poor broader market environment.

Third Point’s multi asset class, long/short approach also offers an attractive alternative to direct equity investment at a time when I believe broad markets are still looking expensive. Historically the fund has provided better than equity returns and Dan Loeb has commented recently that they feel they have become much better at managing volatility lower.

“A manager who has become overconfident by using a bad process is like somebody who plays Russian roulette three times in a row without the gun going off, and thinks they are great at Russian roulette. The fourth time, they blow their brains out.”  Dan Loeb, October 2011


The Listed Vehicle

Third Point Offshore Investors Limited, was IPO’d on the London Stock Exchange in July 2007 and raised $523m, to be invested solely in the Third Point Master Fund via an Offshore Feeder Fund. This may sound complicated but it’s pretty standard hedge fund structuring.

2007 saw a raft of hedge funds listing closed end investment vehicles, some of which have proven successful (Brevan Howard, Bluecrest) and others which have not (Dexion Absolute and Thames River Multi-Hedge). The idea was a means to have permanent capital, with no need to worry about redemptions, and further to raise the profile of the firm through a public listing. There is no additional layer of fees so there is no tracking error between the movement of the company’s NAV and the performance of the offshore hedge fund.

The timing of these listings was poor from the perspective of someone who subscribed at the offering. The market was topping out and hedge funds globally were about to have a pretty tough time through the GFC. Third Point lost 32.6% in 2008 despite being short a large collection of RMBS and banks. It is worth pointing out that while Third Point faced the large redemptions that plagued many hedge funds during the financial crisis, it did not implement a gate or “side pockets”. They met all their redemptions without delay.


Dan Loeb

Interest in Dan Loeb and Third Point should increase on the back of his featuring in the new book “The Alpha Masters” by Maneet Ahuja.

In that interview he says “We’ve never defined ourselves as one kind of firm and we’ve never really deviated from that flexible approach. Instead, we’ve deepened our research process, and hired people who brought us expertise in different geographies, different industries, and different asset classes. Our philosophy is to be opportunistic all the way across the capital structure from debt to equity, across industries and geographies. We invest wherever we see some kind of special situation element, an event that will either help create the investment opportunity or help to realize the opportunity.”


The Track Record

Since inception in December 1996 the Third Point Master Fund has compounded at an annual rate of 17.6% relative to the S&P 500 at just 5.9% over the same period. $1m invested in the S&P compounded to $2.57m compared to $14.5m for the Third Point investors.

Fund returns are pretty lumpy and volatile, for example 48% and 53% in 1997 and 2003 or -38% in 2008. As AUM is now much bigger I would imagine that the returns will be a little bit less volatile as they deal in larger, more liquid instruments now.

In 2009 the fund returned 39%, in 2010 they achieved 35% and in 2011 they were flat. The performance in 2009 and 2010 won them consecutive “Event Driven Fund of the Year” awards presented by Absolute Return magazine.


Current Positioning

For the year 2012 so far the fund is up around 4%.The fund is currently 50% gross long equity with a net long equity of 40%. Third Point is 40% gross long credit and net 20% long. There is a particular focus on long MBS and long Distressed Credit.

Finally “Other Assets” are 21% long and 9% net long. I imagine that a large part of this is their holding in Gold which is the second biggest holding in the fund.



The shares currently trade at about a 21% discount to NAV. This discount was nil at the IPO, and even traded at a slight premium to NAV before the market crash. The discount was widest in late 2008 when all hedge fund investments and anything that seemed illiquid was getting dumped senselessly.


5 Year View

If we are to imagine that a combination of size, vast wealth and a very choppy macro environment makes it difficult for Dan Loeb and his team to generate the same quantum of returns they have in the past. Let’s assume that the CAGR over the next 5 years is reduced to 10% from the 17.4% CAGR since inception. I think this is a conservative forecast because the funds were still pretty large in 2009 and 2010 where they posted great returns.

From today’s NAV of 1166p at 10% CAGR we would get to a 2017 NAV of 1877p. If the discount remains at the current width then the share price will be just under 1500p. If the discount was to be fully closed to the NAV then we would be looking at a total return from today’s share price of 100%.

A bull case would say Third Point can use their large capital base and knowledge across the capital structure to generate great returns over the next 5 years and therefore maintain that 17% CAGR. That gets TPOG to a NAV of 2556p by 2017, a 178% premium to today’s prices.


Below the Radar

The stocks are fairly illiquid, particularly the Sterling denominated one (TPOG) but across the three major currency share classes there is trading volume of around $450,000 per day on average. Not enough volume for wealth managers to allocate across full client banks and this is often the key target market for these closed ended hedge funds.

Listed hedge funds have definitely become an unloved sector as large wealth managers move away from closed ended vehicles to open ended strategies where they don’t have to deal with the problems of liquidity, discounts and bid/ask spreads.

Furthermore, although Dan Loeb is a rock star in the US hedge fund community I have rarely come across a UK based investor who has heard of him! Third Point is not a well known hedge fund in the UK and therefore that must have some impact on the attention granted to “just another” listed hedge fund.

A further soft factor I would mention that I think keeps the natural buyers of Third Point away is the complexity of their strategy. Wealth Managers can tell clients that Brevan Howard’s listed vehicle is a Global Macro fund and that they trade interest rates and currencies; that can just about be communicated effectively. Allan Howard is also one of the richest men in the UK and therefore has a recognisable name.

Telling private clients that you are investing in a fund they’ve never heard of that “goes anywhere across the capital structure”, “invests in special situations”, likes “distressed credits and mortgage backed securities” and that “lost 30% plus in 2008” probably doesn’t play so well.

Kelpie Capital – June Commentary – “A Third False Dawn”

“Each politician pursues self-interest while the common cause imperceptibly decays.” Thucydides.

“Insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” Peter Lynch

“In short, the depression IS the “recovery” process, and the end of the depression heralds the return to normal and to optimum efficiency. The depression, then, far from being an evil scourge, is the necessary and beneficial return of the economy to normal after the distortions imposed by the boom. The boom requires a bust.” Murray Rothbard


Yogi Berra might say that the month was like “déjà vu all over again” as the market plunged after a strong start the year, just as it did in 2010 and 2011. This was the “Third False Dawn” of recovery. Furthermore, the worries remain the same: no self sustaining recovery, continued private sector deleveraging, financial sector balance sheets and of course the intractable European currency crisis. The driver of market returns in the short term will likely be driven by “Volitics” the uncertain interaction of Policy Uncertainty and Volatility.

More to Go?

Paraphrased from John Hussman….“Michael Wilson of Morgan Stanley noted “Make no mistake, institutional investors are all in.” Wilson reported that the monthly rolling beta of mutual funds (their sensitivity to market fluctuations) now exceeds 1.10 and is the highest since the previous record, just before the wicked market plunge in 2011.

Institutions hold their largest “overweight” in high-beta sectors than at any time since the start of data, and long-short funds are also near their most leveraged long positions in history. Of course, mutual fund cash levels also remain at record low levels.”

I have found the contrast between Positioning and Sentiment very interesting over the last few years and here we have another big divergence. Investors are panicked but fully invested. The rock bottom level of sentiment is definitely a short term bullish indicator.

Divergences in Index Performance

The valuation differential between the US indexes and European indexes is becoming quite extreme. The chart below shows roughly a 12% outperformance of the S&P 500 over the MSCI World since Q3 2011.

The currently Cyclically Adjusted Price to Earnings for the S&P 500 is 21.1x in contrast with the UK at 13x and the MSCI Europe at 12x.

Now the question is does the US deserve a 40% premium to the other major developed markets? Some European markets are trading at their 1982 valuation lows, levels from which spectacular future returns were earned. In contrast the US is trading at levels only exceeded at 2 or 3 times in the 130 years of historic data; furthermore each of those times would have been a disastrous time to invest. I am quite confident that on a reasonable time horizon these valuations will meet somewhere in the middle.

I recently attended a course with Andrew Smithers where he summed up this problem of valuation metrics defying gravity for extended periods.

“In the long run stock prices demonstrate negative serial correlation; however in the short run stock prices demonstrate positive serial correlation. The problem is determining at which point the short run becomes the long run.”

My short exposure remains focused on the S&P 500 and the Russell 2000 because I believe these indexes are much more overvalued than their European counterparts and that the emergence of a recession in the US is still perceived as a very unlikely event by the majority of market participants.

The “green shoots” (no mention of them since 2009!) in the US turning to weeds could really be the catalyst for the currently resilient S&P 500 turning lower. Elsewhere, HSBC’s China PMI, the earliest indicator of China’s industrial sector, retreated to 48.7 in May from a final reading of 49.3 in April. It marked the seventh straight month that the index has been below 50. The Euro Zone composite PMI, a combination of the services and manufacturing sectors and seen as a guide to growth, fell to 45.9 this month from April’s 46.7, its lowest reading since June 2009 and its ninth month below the 50-mark that divides growth from contraction. Official data also showed the UK economy shrank more than first thought between January and March, after the deepest fall in construction output in three years, while government spending made the biggest contribution to growth.

“Macro Friday” as some were calling it today was a washout. UK data was absolutely terrible with the UK Purchasing Managers Index posting it’s second sharpest decline in it’s 20 year history. The “new orders” segment was at a near catastrophic 42 down from 49 the month before.

US Non Farm Payrolls came in below the estimates of all 87 Wall Street economists at just 69,000 jobs when we need at least 120,000 to keep the unemployment rate stable.

Will QE 3 or LTRO 2 or a EuroBond Save the Day?

The most important question to answer is; can unprecedented, concerted global monetary policy action repeal the business cycle? Can central banks and politicians conspire to prevent a downturn in the economy? My answer to that would be no, because they have not managed it before. It’s not like the current set of leaders are the first to be extremely averse to a downturn on their watch, these things just happen, growth flows and then it ebbs – it is the natural order of things.

It seems quaint that only a few years ago the concern in Europe was that there would be “contagion” risk resulting from a Greek default. So worried were they that we had almost-daily pronouncements that Greece would not be allowed to default, that there was no need for a Greek default, the developed countries no longer defaulted, etc. Now that Greece has defaulted, the line in the sand is “That was just Greece; no other country will need to default.”

But just in case, European leaders created all sorts of funds, guaranteed joint and severally, to help bail out nations in trouble. First Greece, then Ireland and Portugal. Even with all the money that was raised, it was not enough to prevent a Greek default. And the “new” debt is trading at around 10% of its issue price.

Spain is too big to save and too big to fail. The only way for Spanish debt to remain at 6% is for the ECB to basically buy it (or lend to Spanish banks so they can buy it, or whatever creative new program Draghi and team can think up). When Spain goes the bond market will look to Italy and then to France. The line must be drawn with Spain. The only outfit with a balance sheet big enough that can also do it in a politically acceptable manner is the ECB, and the only way they can do it is with a printing press. I had actually written the first part of this paragraph earlier in the month – on the 31st May the market turned around on rumours of an IMF rescue package for Spain. This is truly absurd, this is exactly the US led (as largest partner in the IMF) bailout of Europe that was categorically ruled out in the past. Another example why ignoring the politicians is the only logical strategy.

From my perspective the market is not yet fully weighing the situation of Spain or Italy becoming more fully embroiled in the currency crisis and/or capital flight via deposits. The Spanish Bond/Bund spread continues to widen.

In Germany, Merkel’s CDU party won 26% of the vote in the North Rhein (Germany’s most populous state) down from 35% in the previous election. Her rivals the Social Democrats got 39% and the Greens got 12%. The Dutch Prime Minister was unable to reach agreement with his government on budget cuts and therefore resigned.

The growing support for extreme parties at either end of the spectrum has been quite predictable. Nothing has been done to address the structural issues in Europe. Painful solutions are postponed and fudged whilst voters refuse to face reality and politicians refuse to speak frankly about the extent of the problems. The time that has been bought by LTRO’s and Quantitative Easing has essentially been wasted.

Videos to View


ECRI re-affirm Recession Call http://www.bloomberg.com/video/92327533/

Charles Dumas on Euro Crisis – http://www.bloomberg.com/video/93285271-italy-stocks-more-overvalued-than-spain-dumas-says.html

Russell Napier on Europe – http://video.ft.com/v/1655932538001/Uber-bear-sees-value-in-Europe

Gold & Gold Miners

Gold has really been dull so far in 2012 basically flat to the end of May. Yet despite this the case for gold is stronger than it was at the turn of the year. The Emperor has no clothes.  See this quote from Eric Sprott

“The fact remains that here we are, in May 2012, and Greece is right back in the exact same predicament it was in before its March 2012 bailout. Before the bailout, Greece had approximately €368 billion of debt outstanding, and its government bond yields were trading above 35%. On March 9th, the authorities arranged for private investors to forgive more than €100 billion of that debt, and launched a €130 billion rescue package that prompted Nicolas Sarkozy to exclaim that the Greek debt crisis had finally been solved.

Today, a mere two months later, Greece is back up to almost €400 billion in total debt outstanding (more than it had pre-bailout), and its sovereign bond yields are back above 29%. It’s as if the March bailout never happened… and if you remember, that lauded Greek bailout back in March represented the largest sovereign restructuring in history.”

In this context then, with the crisis proving chronic why has the gold price been so frustrating? I think it lies in the difference between the demand for paper gold and the demand for physical gold. Traders are liquidating paper gold in a “Risk OFF” play whilst long term investors are accumulating physical to protect their wealth. The net is a redistribution of the metal but no change in the price. Eric Sprott highlighted that China posted another record Hong Kong gold import number in March of 62.9 tonnes. Gold imports into China have now totaled 135.5 metric tonnes between January and March 2012, representing a 600% increase over the same period last year. These numbers are incredible!

Global central banks have also continued to accumulate physical gold, with the latest reports revealing another 70 tonnes of gold purchases completed in March and April by the central banks of Philippines, Turkey, Mexico, Kazakhstan, Ukraine and Sri Lanka.

Despite all of this gold only represents about 0.15% of global pension fund assets. The large institutional pools just do not have an allocation to this asset class. The total market cap of all precious metal miners is about 2/3rds of Apples.

Gold, gold mining and mining investment or royalty vehicles are a substantial holding in my portfolio at around 14%. These stocks are cheap on almost any measure, but the same could have been said a few months ago at 30% higher prices. One way to look at mining stocks is to compare them to the price of gold itself. See below from Sitka Pacific Capital…

While instructive, this measure doesn’t do you a lot of good if the price of gold is set to drop precipitously. Consider the case of 1980, when gold was experiencing an epic top and the mining stocks seemed to anticipate the lack of sustainability of the move, driving ratio of miners to gold to low levels. That said, the ratio has provided a pretty good clue to what future long-term returns will look like. Consider the following chart from John Hussman:

This final chart is something to get excited about – sentiment towards gold miner is now at 2009 lows. The combination of low valuations and terrible sentiment gets me excited.

Will Defensives Always be Defensive?

Murray Stahl made some very insightful points in his latest quarterly commentary regarding the perceived defensive nature of the Healthcare and Defence industries because of their lack of earnings variability.

They highlight that spending on national defence and spending on healthcare have grown year on year regardless of the state of the broader economy or market. This discretionary spending by global governments, particularly in the developed west has been the tide that has lifted all boats in these industries but there is no guarantee that this will always be the case, especially should governments catch austerity.

US government forecasts show that by 2017 they will be spending $104bn less on defence than they did in 2010. After eight decades of constant increases these are profound changes that long term investors must consider.


Kelpie Capital June Factsheet – Performance

For the month of May the FTSE All Share declined 7.3% and the Kelpie Capital portfolio declined 2.1%, a very strong relative result but actually one that disappoints me due to many stocks in the portfolio behaving “riskier” than I believe the underlying economics should dictate. Capital was protected but I still give the month a C+ grade.

Some of the more speculative positions in the portfolio went from cheap to what appears outrageously cheap.

Aberdeen International now has around half it’s market cap in cash and has a portfolio at a greater than 50% discount to NAV. The yield is now 5% and their is a buyback in progress.

JZ Capital Partners reported what I consider to be pretty strong results and addressed several of the issues holding the stock back, the share price barely moved. It has £180m of a £240m market cap in cash, Gilts and listed equities, this allows shareholders to pay only £60m for a £260m private equity and corporate debt portfolio. This doesnt factor in their history of striking profitable deals and growing the NAV.

Yukon Nevada Gold has been the most tortuous investment of my short career. The turnaround is seemingly 80% complete and the mill is running at levels which should allow the company to hit it’s target of >100,000 oz of production. I think they will get there and hopefully when they can confirm this and communicate it to the market the stock should at least double. If they can make a $400 margin on each ounce that would leave them trading on 6x current earnings with the capability to triple production in the next 3 years and the asset backing of a very recently completed $170m refurb on the strategic roasting mill which has conservatively been valued at $500m. Not bad for a stock valued at $270m.
Tullett Prebon is trading on around 6x earnings with a near 6% dividend yield. It is the 2nd largest player in an oligopolistic industry and sits with about a quarter of the market cap in net cash and the CEO with an enormous ownership stake. I get the impression that Terry Smith would find a way to make money in a nuclear holocaust.

Braemar Shipping Services offers it’s owners an 8% dividend yield, trades on less than 10x what could arguably be trough earnings and again has a robust balance sheet with no debt, some property and 25% of the market cap in cash. Despite the cyclical nature of the business, it is owner operated and remained profitable throughout the last downturn which was particularly savage to global shipping.

New Positions

Tullett Prebon

Cisco Systems

Axia NetMedia

Braemar Shipping Services

Positions Added To



British Empire Investment Trust

Positions Sold

Aware Inc



British Sky Broadcasting

Zicom Group (ZGL.AU) – Extremely Mispriced Growth Business


First off, I’d like to thank Joe at http://www.valueinvestingworld.com for alerting me to this idea, his site provides a great source of links/articles from around the web.

In my opinion, Zicom Group at around $0.20 offers investors a low risk and deeply undervalued exposure to a number of “GDP plus” growing end markets with a conservative and proven founding family operating the business. Whilst we wait for the market to re-evaluate the prospects of this business and it to trade at a premium to book value, like it deserves, we get paid a 5% plus dividend yield and allow management to opportunistically buy back shares to increase our ownership. The stock currently trades at a 20% plus discount to Net Tangible Assets.


Zicom has 3 main Divisions comprising the vast majority of revenues and profits.

1)      Offshore Marine Oil & Gas (circa 40% of revenues)

2)      Construction (circa 40% of revenues)

3)      Precision Engineering & Automation (circa 15-20% of revenues)


The Divisions

Offshore Marine Oil & Gas (circa 40% of revenues)

Zicom is one of the world’s leading manufacturers of high spec, heavy duty winches and deck machinery for use on large marine oil & gas vessels. They supply to shipbuilders and ship owners, some of their winches can weigh up to 300 tons and therefore are very large pieces of kit! The key variable for long term winch demand is deep sea oil & gas exploration.

Orders for deck machinery products lag orders for the production of new rigs or vessels by about 12-18 months, this means that the current weak orders still reflects a bit of a hangover from the implosion of demand during the financial crisis. The order book still looks weak at only SGD $42m, or around half of what it was a year ago. We might be hopeful that in 12 months time the order book looks much better.

The main competitor to Zicom in the manufacturer of winches is the UK’s Rolls Royce, obviously a giant in comparison which has its pros and cons. This is clearly a non core business for Rolls Royce and this perhaps allows Zicom to get an edge on customer relations/meeting client needs.

Demand for offshore products in general is likely to be relatively robust above $80 per barrel. The oversupply of vessels from the boom/speculation era and the subsequent slump is starting to clear and E&P companies are starting to spend on projects again.

In the 2011 Directors Report there is reference to a resurgence of demand for offshore rigs which they say has resulted in a “gradual build up” in enquiries which they expect to gain momentum in the next 12 months.


The “Offshore” Marine Oil & Gas division also designs, builds and installs “onshore” turnkey gas processing plants and gas flow regulation systems across Asia. This is a relatively new line of business and is still growing, orders are lumpy and can have a large affect on numbers. There is a goal to grow this part of the business so that is equal with the winch business in doing around SGD $60m per annum revenue.

Zicom supplies process plants for the recovery of gas from refineries. This captures the gas that is normally flared off as part of the process of extraction, separates it and sends it to the refinery. Each plant has a cost of around SGD $10m so they are substantial orders. Alas, the current natural gas price probably is a disincentive for these projects but they still could have a payback period of under 5 years.

As an example of the group’s long term focus and using their robust balance sheet in their favour, they used weakness in May 2008 to deploy SGD $5m into the building of a new factory in Singapore for this division to position it better for the future.

There is a further growth avenue available in “Remotely Operated Vehicles” which are increasingly required for offshore deepwater drilling. The construction division manufactures the frame and the offshore division tailors it to customer spec.


Construction (circa 40% of revenues)

I view the Construction segment as the boring, dependable part of the business. The core of this division is the manufacture of concrete mixer trucks for which they have a dominant 70-80% market share in both Australia and Singapore.

The secondary part of the construction division is the “foundation equipment” business which hires equipment like large vibratory or piling hammers or boring machines. Zicom owns the largest vibratory hammer in SE Asia weighing in at 42 tons!

The division has been revolutionised by the opening of a new production facility in Thailand which consolidates their Australian and Asian facilities and which allows them to increase efficiencies dramatically helping margins. The new facility was a SGD 10m investment to improve the long term prospects of the business and this is already starting to show in margins.  Concrete mixer and foundation equipment demand is of course quite cyclical due to a dependence on construction activity but their geographical diversity and market share helps.

The Australian subsidiary has further diversified into the distribution of gas generators and is looking into waste digesters and biogas generators.


Precision Engineering & Automation (circa 15-20% of revenues)

This division is a specialist equipment manufacturer and niche engineering service provider to customers who require a high degree of specification in their goods, ranging from inkjet cartridges to fully automated production lines to biomedical equipment.


The precision engineering division secured “ISO 13485” accreditation in 2010 which means they can now manufacture entire medical devices in house rather than only being able to make component parts. This accreditation also marks them out as a high quality operator. This competitive advantage has a margin and earnings impact due to pricing power too. The aim here is for the business to partner in co-designing biomedical devices and to make sure that the manufacturing is all done in house too.

Zicom has focused on using its scale to its advantage, focusing on niches and only accepting business that is likely to be profitable and ideally recurring so that a relationship can be built with the customer and revenues become more predictable.

In the last 2 years the group has made a substantial commitment to this part of the group by doubling the floor space of their factory and by making three strategic investments in start up companies which possess “disruptive technologies” which can be manufactured and monetized through this division’s expertise. Zicom has targeted “high valued added synergistic products” that have the potential to revolutionize their industries, these are clearly high risk/high reward targeted investments in areas close to their existing operating circle of competence. Any one of these products being a “hit” could result in exponential earnings growth and they already have the factory capacity to grow into.


3 Shots at a Home Run within Precision Engineering

1)      BioBot Surgical (46% ownership for SGD $3.5m)

This is a surgical robot for taking prostate samples for biopsy. This robot has been proven to increase sample accuracy and minimises patient embarrassment and invasion.  A study in Singapore’s largest hospital showed that over 4 years it doubled detection rates. The product has received regulatory approval in Singapore, Australia, Europe and the USA.


2)      Curiox BioSystems (40% ownership for SGD $3.2m)

Pharmaceutical research and diagnostic testing scientists require plates for their assays. Curiox has developed a “drop array” technology which has proven to be more accurate, increase the speed of the cleaning process, improve productivity and lower costs. Testing with a “leading US Pharmaceutical company” showed a reduction in cost of use of 85% and a 60% saving in time. Curiox has sold 2 units so far (as of June 2011) to the US company and to a Japanese pharma who are now using it for real production.


3)      Orion Systems Integration (54% ownership for SGD$2.55m)

Progress has led to computer users expecting greater power on smaller devices over time which requires chips to be smaller and lighter too. Orion possesses a technology in “Thermal Bonding” which overcomes the limitations of conventional bonding whilst improving performance.

The attractive thing about this basket of investments relative to the share price is that most of the investment is complete having purchased the equity stakes and secured regulatory approvals/testing. The cost of failure from here is minimal but yet the upside is potentially very high.


History of the Company

Zicom was established in 1978 by the Chairman GL Sim and took itself public in 2006 by way of a reverse takeover. The business has grown via small acquisitions and organic growth. This is, and has always been, a family business with a focus on long term, profitable relationships and a strong internal culture. GL Sim owns 35% of the business and is Patriarchal figure which ensures very low staff turnover and a collegiate approach. Both of his sons are in the business after completing their education at prestigious US Schools

JK Sim also owns 10% of the company. The Chairman’s two sons own 1% of the company between them.

Insiders have purchased 1.3m shares over the course of 2012 so far. Looking further back, they have purchased 15.6m shares (7.3% of shares outstanding) in the open market since May 2010. This is a very strong signal that those closest to the company believe it is substantially undervalued. Some of these purchases were done 50% above current prices and 500,000 were bought at double the current price. I couldn’t find a single insider sale in that period. Either the family are just totally wrong about their business, which is possible, or they are really taking advantage of Mr Market’s myopia.


Capex done, now for the rewards?

Capex has been at a high level for the last few years with the investments and new floor space in Precision Engineering, the Thai factory in Construction and the factory in Singapore for the Marine business. Going forward, management have guided that this will be lower although they retain flexibility to make strategic acquisitions/investments into the disruptive technologies they are starting to favour.

In the 2011 annual report management highlighted that they had forecasted $3m of capex in the current year, the reality is likely to come in below $2m, an indication of their prudence.

It is worth highlighting that the cash pile within the company and the quality of their PPE has been growing and improving throughout the last 5 years which has included dividends, all that expansionary capex and a global financial crisis. If they were to start to run the business for current profits or cash flow the effects could be remarkable.


Ownership Structure – Long Term Family Business

The comments of the Chairman GL Sim ooze conservatism and suggest a broad macro perspective, giving me great comfort that he is the steward of this business. From his November 2011 Chairman’s Address

“The world’s global economic situation has deteriorated with the possibility that the fall-out could be worse than the 2007-2009 Global Financial Crisis.”

“It is therefore prudent to assume that the current financial crisis that follows seamlessly from the GFC can be expected to inflict serious damage that may last for some years to come…..(economic) cycles for changes have become shorter and sharper.”

“The key planks of the Group’s sustainable growth strategy consists of continuous focus on strengthening our organic growth while embarking on synergistic acquisitions and investments in disruptive technologies fully financed by internal resources. These form the buttressed foundation of our growth platform, to position us to weather economic adversities rearing in our horizon.”

“The group is continuously looking for opportunities for expansion….Such opportunities may arise during periods of adversity. We position ourselves to be ready for it.”

From the 2011 Annual Report

“The group achieved record revenue and profits for the year just ended. These results have been achieved from the groups focused efforts and directions. The Group’s focus in continuously growing organic growth and, at the same time creating avenues for horizontal growth, by investing in disruptive technologies from its internal resources has buttressed the Group to achieve sustainable growth into the future.”

GL Sim, the chairman, has committed to the business for a further 5 years with his salary frozen at 2007 levels – something that even more closely aligns his interests with the performance of all the equity he owns.


Balance Sheet Strength – Trading Below Tangible Book Value

The last time the shares were trading at this level in September 2010 coincided with the company initiating its first buyback programme. The share buyback programme was renewed on September 1st 2011.

It’s worth remembering too that the A$28m of Property, Plant and Equipment on the balance sheet is supported by the substantial investments made in 2008 and 2010 in large, new factory space which will likely still be worth around the same amount. The point being that these book values are not unrealistic prices.



Knowing that Zicom Group is trading below Net Tangible Assets we already know that we have a margin of safety in the stock, now we can make a conservative assessment of what the stock might be worth if the market afforded it a reasonable valuation.

To be conservative, we will assume that all three investments in the disruptive technologies flame out and produce no earnings. This seems extremely unlikely since they have already started generating sales and seem to provide genuine advantages over their incumbent technologies but let’s run with it.

Over the last 6 years which includes the GFC the average earnings for Zicom were A$0.045 per share. Six years ago Zicom had a much smaller capital base and had revenues of only A$35m which is only about 30% of 2012 expected revenue.

Putting an 8x multiple on these cyclical earnings we get to a share price of A$0.36 which is almost a double from here. I think we can agree that these are very conservative estimates.

It is also worth re-iterating that the company has remained profitable throughout the crisis and has the balance sheet strength to capitalise on economic weakness rather than fall victim to it.


Exchange Rate Risk in Earnings

ZGL earns the majority of its revenue in Singapore Dollars but yet the listing and earnings will be in Australian Dollars. Therefore there is substantial conversion risk each quarter to make earnings more volatile than they truly are. Weakness in the Australian Dollar will make earnings appear better than they actually are, strength in the Aussie will make earnings appear weaker than the economic reality.


Way Below the Radar – Sloppy Analysis

“Overseas Discount” – one of the very few research reports I could find of Zicom stated that the fact that management are based in Singapore and operations are based in Thailand and Singapore that this is sufficient to justify a permanent valuation discount. Ehm, the last time I checked Singapore was pretty “first world”, I don’t think this makes any sense at all. The rule of law is very much applicable in Singapore.

One broker ceased coverage of ZGL despite previously having a price target of $0.85 (a four bagger from here!) because they have a lack of confidence in forecasting earnings due to inconsistent outlook statements. I suspect that it might be more to do with a “what’s in this relationship for us?” though process.

The stock “will not appeal to many investors” due to the smaller market cap and limited liquidity. Unfortunately, this is probably correct but just because it doesn’t appeal to institutions that like to play on the safest of grounds doesn’t mean that it doesn’t offer an attractive opportunity.

The “share buyback should be suspended”, this was justified in that it makes an illiquid stock even more illiquid by retiring shares that were once in the free float. However, at such a steep discount to tangible value there is a substantial value add to buying back shares at current prices and this mindset has no consideration of an ownership mentality.


Why has the Share Price collapsed?

One large passive owner (Ventrade Pte) owned 8% of the company and has been liquidating their stake over the last year, this has resulted in an uptick in volume and a consistent, fairly inconsiderate seller.

The tiny market cap of only $40m AUD ($20m free float) means that anyone with a capital base of more than $10m will struggle to pick up sufficient stock or bother doing the due diligence.

The most recent earnings report was very weak with revenues, margins and profits all declining substantially. This means that the stock has seemingly poor operating momentum and doesn’t look particularly cheap on a multiple of current year earnings basis. These factors above plus the cyclical nature of their business operations means most investors will stay well clear until there is greater clarity on the outlook.