Description
Addenda stock presents an opportunity to own a very high roic, growing business at an undemanding valuation, and to be paid a 5.5% yield while you wait.
Addenda is fixed income investment manager based in Montreal with approximately $28 billion (all figures are in Canadian dollars) under management, that serves institutional clients (roughly 2/3 of the assets come from Canadian pension funds). The business was founded by Carmand Norman in 1996 with less than half a billion in AUM and has grown entirely organically over the last 10 years. Addenda is an active investment manager – its investment strategy is to annually forecast the Canadian long bond yield, and then adjust duration of the portfolios throughout the year to take advantage of interest rate volatility compared to the firm’s target or “equilibrium” rate. For most clients, Addenda’s goal is to beat a benchmark (either the SCU Index or the SCM Long Term index) and over the long-term investment performance has been good – from 1996 thru 2005 Addenda’s largest composite beat the relevant benchmark by 84 basis points, before fees, annualized, and its second largest composite beat its index by 72 bp annualized. This long term outperformance includes underperformance last year, where the two largest composites underperformed by 116bp to 215bp – this year Addenda had outperformed for the fist six months of the year, but a poor relative third quarter has left the firm flat to slightly trailing the benchmarks for the year. Both recently and through its history, asset retention has been high, and fees are based on assets under management, and in very limited cases on investment performance.
The business is extremely profitable – in 2003 ebitda margin was 63%, in 2004 it was 64%, in 2005 it was 68% and for the first nine months of 2006 it was 70.5%. Return on invested capital is off the charts. For example, last quarter’s net income annualized works out to $17.5mm, yet there is only $13.4mm of book equity (and no debt), and of the net worth, $11.6mm is represented by cash and liquid investments. The assets are the people, the record, the reputation with clients. The point is that this is a business that does not require capital to grow, and should be valued like one.
As useful exercise is to prepare a simple DCF and use it as a sensitivity analysis to understand the expectations that may be embedded in today’s share price, and what Addenda stock may be worth under different growth scenarios. For example, “street” estimates for 2007 eps are between $1.61 and $1.66. If I say year one eps, which is equivalent to free cash flow per share, is $1.61, and it grows at 5% a year for the next five years, and then grows in perpetuity at 2.5%, at a 10% discount rate the business value per share is $24.78, plus almost a dollar per share in excess cash and investments gets to $25.75, or a little over today’s price. Obviously punching out prices down to the penny is moronic, but the exercise is I think instructive – chiefly because I think the above growth assumptions are way too low and they still gets to a higher price than today’s. For example, I think that even if Addenda gets no net additional inflows from clients (but does not have net outflows either), 5% a year growth is a realistic forecast of what Addenda will get just through investment performance (I assume no margin leverage), and then I am assuming it can only do it for 5 years and then the growth falls to a level more reflective of inflation than what I think they can investment performance will be (or maybe they have decent investment performance but have net redemptions).
If I try another, more realistic I think scenario, that FCF grows at 10% thru 2010, then has 2 years of 8% growth, then 3 years of 5% growth before falling to 2.5% into perpetuity, then the total share value (including the cash) gets to $31.56. My guess is these are not heroic assumptions, given that in every year Addenda had had net asset contributions, and would seem to have an opportunity to grow assets via new geographies. The new geographies idea is this: as of 12/31/05 65% of the AUM was from Quebec based clients and 30.5% was from clients based in Ontario. The percentage for Ontario would be slightly higher now given that a more of recent AUM adds have come from Ontario, but there would seem to be a good opportunity to grow market presence here – management has stated that is believes the relevant market in Ontario (where it has had an office since 2000) is 2-3X the size of Quebec’s. Additionally, management feels there is a long-term opportunity to grow in Western Canada, which it believes is a relevant market as large as Quebec, but where Addenda has almost no presence currently. For what it’s worth, management in its IPO roadshow (late 2004) indicated it expected 10-15% profit growth over the long pull. The second scenario also works out to a p/e of 19X, which is about in line with where U.S. asset managers (which are not as capital efficient) like TROW or EV trade. If, as a third scenario, management’s 10-15% targets were met, the stock would be worth considerably more.
Additionally, with addenda you get a big dividend and a management team aligned with shareholders. Addenda currently pays a dividend of 32 cents quarterly, which at Friday’s close works out to a 5.5% yield. The dividend has been raised now for several quarters in a row, and is still below the 90% payout ratio target that management stated on one of the conference calls, and of course I expect earnings, and most likely the dividend, to continue to grow. Another point worth mentioning is that almost all Addenda employees are shareholders and that senior management owns about 23% of the stock – it would stand to reason that they care a lot about dividends and long-term share price appreciation.
The obvious risk to the story would be sharp or sustained investment under-performance that could cause Addenda to lose assets.
Catalyst
Long-term groth in AUM, earnings and dividend.