Description

Date: 8/24/09

Idea: Long Arctic Glacier Income Trust (TSX: AG-U CN Equity)

Price: CAD$1.72 (US$1.61)

Mkt Cap: CAD$67m (US$63m)

P/E: 3.7x

TEV/EBITDA: 5.3x (4.5x normalized for seasonality)

Arctic Glacier offers the opportunity to purchase a highly cash generative business with steady end-market demand at a cheap valuation owing to uncertainty over an industry anti-trust investigation and refinancing risks.

This is an idea for PAs only - mkt cap ~US$60m, trading volume ~$125k/day.  Nonetheless I'm writing up for VIC as I've dug up some interesting proprietary information.  I believe the idea offers ~3x upside with limited downside.

Investment Thesis:

• Strong core business, cash flow generation - packaged ice (bagged ice at convenience stores, supermarkets) is a steady, albeit weather-sensitive business. Company generates ~$30m cash per year (post capex), $50m before debt service
• o Presently trades at 50% free cash flow yield to equity
• Valuation hugely discounted by pending anti-trust investigation and upcoming debt maturity (down 88% from peak)
• o Expect anti-trust fines & related lawsuit settlements to be serviceable out of cash flow - supported by proprietary research with leading academic in the field of antitrust fines
• o Expect DOJ to conclude prior to upcoming debt maturity allowing debt to be refinanced - if DOJ not concluded in time, expect $60m maturity can be extended for reasonable fee
• Insider buying - industry mgmt clearly not as concerned about antitrust suit as public market is
• o Arctic Glacier CEO bought 40k shares in open market since Sept '08
• o Reddy Ice (main competitor, subject to same antitrust investigation) insiders have bought 210k shares in the open market YTD - stock up 130% over last 9 days on back of announcement of new 10b5 stock purchase plan
• 3x upside in expected case, DOJ fine & related lawsuits could be much larger than the expected outcome and stock is still fairly priced
• Near term catalyst in DOJ resolution - both companies expect nearterm resolution, DOJ investigation has gone on longer than usual since the first party plead

Company Description:

Arctic Glacier (US$1.61/share, 3.7x P/E, 5.3x TEV/EBITDA) is a leader in the packaged ice industry in North America.  The company markets its packaged ice under Arctic Glacier Premium Ice brand name to retail customers, such as supermarket grocery stores and convenience stores, as well as to various commercial users, including airlines, bakeries, and meat and poultry processors. The company also sells its ice in bulk quantities to various industrial users, including the food processing, construction, chemical manufacturing, and commercial fishing industries. In addition, Arctic Glacier sells other products, such as bottled water, dry ice, packaged wood, and rock salt, as well as sells and leases ice-making and dispensing equipment in certain markets.

The Company is a Canadian Income Trust and historically has not paid corporate level taxes.  Due to a change in law in 2006, all Canadian Income Trusts will lose this favorable tax treatment beginning in 2011, (assumed full Canadian tax load in all analysis).

Industry Overview:

Packaged Ice industry is dominated by 2 large players - Reddy Ice (35-40% mkt share, concentrated in southern half of US) and Arctic Glacier (~25-30% mkt share, concentrated in northern half of US & Canada).  The remainder of the market is made up of a few smaller regional players and mom & pop outfits, the market is regionalized due to transportation costs.  The two leaders have been aggressively consolidating for the past 5 years.  Aggregate demand for ice is steady on the whole - volume growth of 1-3%, pricing growth roughly at cost inflation.  Cash flow is highly seasonal for both companies - 1^st half is typically cash flow negative with the full year's cash generation coming in the 2^nd half.

Anti-Trust Investigation:

Background:

• In March '08, Arctic Glacier, Reddy Ice & Home City Ice (non-public midwestern player) received subpoenas from the DOJ regarding anti-competitive practices - general allegation is that the large players conspired to carve up turf across the country and avoided competing with each other
• o DOJ raided Reddy Ice's offices in March '08
• o Multiple states followed with their own investigations, customer and shareholder lawsuits followed as well, there is a second DOJ civil investigation under the false claims act for ice supplied to government entities
• o A former employee of Arctic Glacier sued under RICO claiming he was terminated because he refused to participate in the scheme
• Both Reddy Ice and Arctic Glacier have fired their head salespeople as a result of the investigation
• o DOJ likely has both firms dead to rights - an informant supposedly taped meetings for the FBI
• Home City Ice reached a plea agreement with the DOJ in June 2008, sentencing guidelines are for $24-48m fine - though this number is typically discounted significantly in final resolution, as discussed below. This is standard operating procedure for the DOJ to settle early with a smaller player in the market and use that as leverage to force a settlement with the larger players.

Sizing DOJ fine & related lawsuits:

I found a number of research papers put out over the past 10 years from an economics professor who is a thought-leader on optimal deterrence theory and sizing of DOJ and European antitrust fines in practice (I'll refer to him just as "The Professor" so he doesn't get incoming calls on this).  The Professor has a database of >100 DOJ fines for domestic companies and has cut & diced the database to produce a regression with strong explanatory power (R²= 71%).  In my discussions with him, he was kind enough to take on this project to use his historical regressions for predictive purposes.  As an aside, I'm trying to help the Professor find a way to commercialize the academic work he's done.  If any members of VIC community need anti-trust fine expertise please get in touch with me and I'll introduce you. 

Assuming 100% of each company's sales are "affected sales" (affected by anticompetitive cartel activity), he expects anti-trust fines of $45m for Reddy Ice and $25m for Arctic Glacier, with private market settlements (customers, shareholders etc.) approx. 1.75x the size of the anti-trust fines.  Using the high end of these numbers, that means approx. $125m for Reddy Ice and $70m for Arctic Glacier. 

It's important to note that Home City Ice has already entered a plea agreement that suggested $24-48m of DOJ fines.  It is my understanding however that this is Home City's "pre-discount" number (headline guidance, but real numbers come in much lower).  The Professor expects the final DOJ fine to be approximately $2-5m for Home City.  It is also important to note the DOJ takes "ability to pay" into account when assessing fines and generally tries not to put companies into bankruptcy.

Upcoming Debt Maturities:

Arctic Glacier has a $60m 5.35% note due January, 2010.  Unless the DOJ situation is resolved prior thereto, it will be difficult to refinance this debt.  I expect Arctic Glacier will be able to reach a settlement in Q3 or Q4 this year, given the time that has elapsed since the DOJ received it's first plea from Home City Ice.  However, it is difficult to anticipate DOJ timing with conviction.

Assuming the DOJ settlement remains unresolved in January, I expect Arctic Glacier can extend the maturity on this debt for a fee -- perhaps 300bps ($1.8m) and an upward revision in interest rates.  The debt is 100% owned by John Hancock, the insurance company.  I haven't been able to reach the right portfolio manager, but speaking with a few bank desks I understand they don't have a reputation for being particularly harsh on borrowers.  I expect they still feel safe in their senior secured note - total senior secured debt is covered by tangible assets (1.0x 6/30 at seasonal peak, 1.25x at year end) and sr. sec. debt / EBITDA is 3.1x at 6/30, 2.4x at year end. 

The remainder of Arctic Glacier's debt comes due in 2011 - the $161m L+175 revolver ($128m drawn at 6/30 w/c peak) is due in May, 2011.  C$100m of 6.5% subordinated converts are due in July 2011.  Arctic Glacier will have to refinance all this debt at once and face today's interest rates once the DOJ fines are known.  I've assumed they do this at the start of 2010.

The Company will generate ~$50m of cash between June and Dec (per table below, est. $57-58m cash from ops, $7.5m capex), bringing existing secured debt balance down to $138m and total debt to $210m.  For refinancing needs I've assumed $215m funded debt and a seasonal revolver.  This represents 3.5x leverage.

I expect that Arctic Glacier will have to pay high interest rates even with clarity on DOJ penalties and reasonable 3.5x leverage on a highly cash generative business.  I've assumed $150m sr. secured debt (2.5x leverage, 3.25x leverage at seasonal w/c peak) would be priced around 9% (call it L+700 with a 2% LIBOR floor), and $65m of unsecured debt (3.5x leverage through unsecured) would be priced at 13%.  All-in, this would be a blended interest rate of approx. 10%. 

Worst case - if John Hancock forced redemption and Arctic Glacier had to do a dilutive equity offering for the full US$60m maturity at a 15% discount to mkt price (C$1.28/share), this trade would still return 1.9x based on the valuation methodology below.

Valuation / Potential Upside:

Normalized EBITDA -- I expect normalized EBITDA from Arctic Glacier of ~$60m going forward.  Arctic Glacier achieved $65m of EBITDA in 2007 (normal to slightly warm weather conditions).  Arctic Glacier has closed ~$32.5m of acquisitions since the 3^rd quarter of 2007, adding ~$3-5mm of EBITDA to total $68-70mm of EBITDA on a normalized basis.  However, we reduce EBITDA by 10-15% to reflect the poor consumer spending environment and the assumption Arctic Glacier will lose the benefits of historical anti-competitive activity.  This results in estimated steady state EBITDA of ~$60m under normalized weather conditions.  Note: expect 2008 was a period of ramped up competition between ice makers as they were careful to avoid any ongoing collusion while under DOJ investigation.

Valuation - So once uncertainty on antitrust fines and refinancing are behind Arctic Glacier, what's it worth?

Keeping it Simple - EBITDA multiples

These are simple low growth, steady high cash flow businesses.  In the roaring 2000s, they spent most of their time around 10-12x TEV/EBITDA.  In fact, following Reddy's 130% stock market run up in the past few days, Reddy Ice is now at ~7.4x EBITDA now before any antitrust penalties.  On a go-forward basis I expect 8x EBITDA, post payment of antitrust fines, is a reasonable trading level and fair value for Arctic Glacier. 

I use the simplifying assumption that DOJ/private lawsuit penalties are all paid immediately - in reality these payments will be structured over 5+ years and paid out of cash flow.   At an 8x valuation, as shown below, expected equity return is 3x.  Actual DOJ fines could be 3x higher than the Professors' calculations and the investment would still return your money at an 8x stabilized EBITDA multiple.

Confirming - Discounted Cash Flow to Equity

Because this situation takes into account a few moving pieces: refinancing at higher interest rates; the Company becoming a cash taxpayer due to change in Canadian Income Trust law; DOJ penalties and private lawsuit settlements paid out over time -- we checked this outcome against a simple DCFE as well.

Key assumptions include:

• Sub-normal 2H09 cash generation (antitrust costs, poor weather)
• $60m stabilized EBITDA in '10, growing 3% a year
• No cash contribution from w/c (consistent source of cash historically)
• Full 35% Canadian tax load (actual taxes likely less)
• Expected DOJ fine of $25m and civil lawsuits settlement of $43.8m per the Professor
• 12.5% normalized equity required return (after DOJ and refinancing issues pass)
• 10% cost of debt (9% on sr. sec. at 2.5x leverage, 13% unsecured at 3.5x leverage as per above)

This valuation produced a similar >3x return on the stock.  Key assumptions (equity discount rate, average cost of debt, multiples of expected DOJ fine & private lawsuit settlements) are sensitized below.

Key Risks:

• Higher than expected DOJ antitrust penalties and private market lawsuits - these numbers are difficult to predict. However, the Company could sustain up to 3x the Professor's expected fines and still be fairly valued at today's price.
• Arctic Glacier unable to refinance debt and forced into dilutive equity offering to retire $60m debt due in Jan '10 - I expect that either the DOJ case will be settled by this maturity (as evidenced by insider buying in Reddy Ice and comments from mgmt), or that Arctic Glacier will be able to extend the maturity on the $60m notes.
• o The notes are held entirely by the John Hancock, the insurance company, which to my knowledge does not tend to be aggressive with borrowers. Further sr. secured debt is sufficiently covered -- 1.0x tangible assets coverage at w/c trough, 1.25x at year-end. ~2.3x sr. sec. leverage at year-end.
• o If Arctic was forced to do a dilutive offering to retire the $60m maturity at ~15% discount to today's stock price, trade generates an expected 1.9x return
• 2009's Q3 will be very poor, last thing this company needs as it tries to refinance debt. It has been unusually cold throughout the Northern US. Prior year comp is light already due to a cold season last year, I expect full year EBITDA ~$55m in 2009.

Overall - this is a high risk trade.  Pending DOJ fines, customer lawsuits and refinancing risk in this environment should not be brushed aside.  However, in my view the lucrative potential upside, and the cushion at this valuation to absorb adverse outcomes on fines and interest rates provide enough margin of safety to take a real look.  But be prepared for a bumpy ride.

A Note on Reddy Ice:

Reddy Ice (NYSE:FRZ) was my initial focus in this analysis.  Reddy has slightly larger scale, higher levels of insider buying, 4x the daily trading volume and no debt maturities until 2012.  Further, Reddy was able to attract CEO Gil Cassagne (a very capable and intelligent exec from Cadbury I've had the pleasure of working directly with in a prior life) after the antitrust lawsuit was already public - a real demonstration of confidence from Gil that the DOJ situation will be manageable.  Valuation aside, I prefer Reddy Ice.

However, the 130% price runup over the past 9 days has taken the juice out of Reddy's upside (trading at 7.5x BEFORE accounting DOJ/private lawsuit fines).  Either something bigger is going on here or the public markets are being their usual silly selves - 130% price response and a week of $10-15mm/day volume in a stock that usually does $400k/day is quite an outsized response to a 10b5 plan filing with no details.  If any of you can get past the crazy trading patterns and have the wherewithal to short Reddy or do a pair trade, by all means do it -- I can't short in my PA and FRZ may not be easy to borrow.  However, if Reddy starts drifting down to the $2.50 level again it would be an interesting buy. 

Catalyst

 Plea agreement with the DOJ - expect by year end. Settlements with customer/shareholder lawsuits - expect shortly thereafter.