Description

Overview

 

Endeavour Financial Corp (EDV CN) is a merchant bank focusing on the global natural resource sector.  Following the acquisition of 100% of its advisory affiliate in July 2007, the company is a fully integrated from the deal origination and advisory role to the capital investment for the company’s balance sheet.  The company has had success within both roles. Since 2002, Endeavour has advised on the arrangement of M&A transactions valued at $27 billion, including Northern Orion in its three way combination with Yamana and Meridian and Wheaton River in its sale to Goldcorp.  The company has had huge success in its proprietary investments, generating an IRR of 73% per annum from 2002 to the end of 2007 versus returns for the S&P Metals & Mining Index of 24% and the S&P TSX Composite of 17%.

 

Despite the consistent success (total b           ook value per share has grown at a CAGR of 50% from December 2001 to December 2007 and increased every year) the shares at C$5.75 trade at a 25% discount to cash and liquid investments.  The resource sector selloff, which has hit Canadian small caps the most, has completely demolished this stock.  At the current price I believe that it offers a very compelling risk/reward for long term investors, even those not expecting a bull market in natural resource stocks.

 

Before delving more into the business description and background, let me break down the market cap and enterprise value.  All numbers are in Canadian dollars.

 

Stock Price                            $5.75  -- 25% below my basis L

Basic Shares                           34.5  -- note: have 2.8mm buyback authorization

Earn-out Shares                       3.5   -- from acquisition of advisory affiliate

In Money Warrants                3.5   -- ignore treasury method buyback

Total Shares                            37.9

Market Cap                           $217.9

 

Net Cash                                $49.1  -- this is true cash as of 3/31/08

Investments                          217.4  -- composition and pricing policies below

Cash and Investments        266.5

Enterprise Value                   $(48.6)

 

Investment Portfolio

 

Of the $217 million investment portfolio, less than 3% is in privates (generally marked at cost) and warrants (marked using Black-Scholes).  The vast majority of the portfolio is invested in liquid securities across the resource sector.  The company applies a liquidity discount when appropriate based on any lockups or other restrictions on sale.  The breakdown by industry, geography and company type is as follows:

 

Region                                                Weight           Stage                     Weight              Industry               Weight

Latin America                             59%               Producing              60%                  Gold                       30%

Eastern Europe & Asia                       10%               Development        29%                  Oil & Gas               27%Africa                                         8%               Exploration            11%                   Copper                 12%

Oceana                                                   8%                                                                           Other Base           8%

Canada & U.S.                                      8%                                                                            Platinum               7%

Early Stage & Other                             8%                                                                            Uranium                2%

                                                                                                                                                  Other                     14%

 

So the portfolio is heavily weighted towards producing and near-producing (development stage) companies in the emerging markets.  One oddity of this portfolio is that the cash and highly liquid securities held within the portfolio are sub advised out to U.S. Global Investors, which is run by the highly visible and somewhat wacky Frank Holmes.  Many VIC folks will be familiar with GROW which has been written up and discussed often.  Endeavor’s expertise is in turning junior resource companies into mid caps and eventually majors.  Frank Holmes is a stock picker, and an excellent one based on the long term relative performance of his mutual funds.  The company’s flagship fund is the Global Resource Fund (PSPFX) which has generated a CAGR of 21% dividends reinvested for the 10 years through August 8, 2008 (includes the recent bloodbath in the resource sector) versus less than 9% for the S&P/TSX Metals and Mining Index and 8% for the Amex Oil & Gas Index.  In exchange for its portfolio management role, U.S. Global Investments receives a 1% management fee and 10% of profits over an 8% hurdle rate..  Also, Frank is the chairman of Endeavour, is active in generating deal flow for the company and enjoys rambling aimlessly on Endeavour’s earnings calls.

 

Two other points worth mentioning.  First, Endeavour is based in the Cayman Islands and does not pay taxes on its prop capital.  Taxes are paid on the advisory business; though it is a global business and the weighted average tax rate is under 20%.   Second, the company does not like to provide position level transparency where it can avoid it.  They are not promotional and would prefer to compound book value per share each year and have investors focus on that rather than the short term fluctuations of its holdings.  Management also likes to keep a lid on what it is doing as they want the ability to invest more in the smaller companies at good prices.

 

Advisory Business

 

This is not a case where the stock is simply trading below tangible book and deserves to trade at book (i.e. $7.03 per share or 22% higher than the current price).  In fact, as I will detail in my valuation section, I think it is prudent to take additional haircuts to the portfolio to provide a cushion for further declines or decrease in liquidity.  This “buy a dollar for 88 cents” story would be the case were it not for the highly profitable advisory business that Endeavour now owns 100% of. 

 

The advisory affiliate was purchased in July 2007 for $103mm including the value of the earn-out shares likely to be granted.  The average EBITDA for the four years prior to the July 2007 closing of the transaction was $12.5 million.  In the fiscal years ending June 2006 and June 2007, the advisory EBITDA was $17.0 and $22.9 million, respectively.  In the 8 months from the time the deal closed to the end of the March quarter, EBITDA was $13.4 million, implying an annual run rate of $20 million.  It is important to point out that the EBITDA figures are net of the payout to the bankers.

 

Management indicates that the deal flow is very strong and accelerating.  The business of brokering capital raises and M&A for junior resource companies does not necessarily require surging stock prices.  Baja Mining (BAJ CN) is a good example of a company that has used Endeavour to raise capital in numerous tranches and of increasing complexity despite a plummeting stock price.  The Korean consortium that provided the capital this July simply got a better deal and Baja a more dilutive one.  Endeavour printed its ticket.  I should point out though that in the case of Baja, the company has invested in the stock at different points of time and is obviously losing money as the stock declines.  The various transactions done for Pacific Rubiales (PEG CN) is another example of a company that needs an banker with deep ties in its industry niche, and can step up with its own balance sheet to participate in a capital raise if it so chooses.  Furthermore, struggling junior resource companies will eventually get picked off by the better capitalized majors.  While this may not elevate the stock prices of the sector, again it represents deal flow for Endeavour.

 

Valuation

 

First a quick and dirty example of how the two components of the merchant bank can be aggregated from a valuation perspective.  I think a reasonably conservative EBITDA assumption for the advisory business is $18 million, which is less than the annualized 8 months since deal closing and less than last fiscal year.  This equates to 5.7x EBITDA using the $103 million purchase price.  If the market pays March 31 tangible book value, then stock is worth $9.75 (75% upside).   Looked at another way, using the same $103 mm valuation for advisory, the company’s $217 million stock portfolio (excluding cash) would need to fall by over 70% to $60 million to justify the current market cap.

 

The following table shows different stock prices when changing the assumptions on the value of the portfolio and appropriate valuation of the advisory business.  The first low case assumes that the advisory business is worth what Endeavour paid for it, or 6.9x an EBITDA figure that is below last year and the run rate so far post deal closing.  Then it shows that you would need the stock portfolio to be worth just 30% of its March 31 value in order to equate to the current Endeavour stock price.  The second low case just illustrates the result of just ignoring the advisory business.  Without any contribution of value (total write-off) from the advisory business, you would still need to take approximately a 20% discount to the value of the stock portfolio to equate to the current stock price.  The mid case uses the $103mm purchase price to value the advisory business and takes a 20% haircut to the portfolio.  The high cases uses 10x EBITDA for a growing and industry leading advisory business and assumes no haircut to the prop book.

 

 

                                                                                Low #1                   Low #2                   Mid                         Upside

Value of Advisory (mm)                                      $103                        zero                        $103                        $125

Multiple - $18mm EBITDA                                    6.9x                         0.0x                         6.9x                         10x

 

Cash                                                                         $49                          $49                          $49                          $49

Unadjusted Portfolio Value                                $217                        $217                        $217                        $217

% of Value Portfolio Assumed                          30%                        80%                        80%                        100%

Adjusted Portfolio Value                                    $65                         $174                        $174                        $217

Adjusted Cash and Portfolio                             $114                        $223                        $223                        $266

 

Total

Total Value                                                            $217                        $233                        $326                        $391

Value Per Share                                                    $5.75                       $5.88                       $8.59                       $10.32

Return from Current                                               0%                          2%                        49%                        79%

 

 

I won’t spend time debating the merits (or lack thereof) of investing in emerging natural resource companies.  From my perspective, those bullish on the sector can adjust the base case to reflect less of a haircut to the portfolio and/or assume that the advisory business flourishes in a dynamic environment with literally thousands of companies seeking to grow and develop their projects.  What strikes me as more compelling is the downside protection.  The current market cap implies that the advisory business is worthless and that the portfolio takes a 20% hit.

 

I alluded to the fact that the company does not provide stock level transparency but that there are benchmarks to give some approximation of performance since the latest reported book value, at least directionally.  From the end of the March quarter to the end of the June quarter, the best such proxy, the U.S. Global Investors Resource Fund (PSPFX), increased 24%.  Core holding Pacific Rubiales was up 50% while Baja Mining was flat.  So the June quarter should be strong as far as portfolio performance.  I believe that with the closing of several advisory deals, the fiscal fourth quarter should be strong from that side as well.  Since the end of June, the sector has gotten killed.  It is my belief that many small cap resource stocks are compellingly cheap.  Given that this is just one VIC member’s view, I think it makes sense to look at the 50% return under the scenario that the advisory business is worth what was paid for it and the portfolio declines 20%.

 

The other methodology I used is an ROE analysis:

 

Tangible Book  Value 3/31/08                                            $265 mm (a)

Assumed Long Term Return on Portfolio                        12%                        (b)

Portfolio Income                                                                   $32 mm

 

Assumed Run Rate Advisory EBITDA                           $15 mm                   (c)

Tax Rate on Advisory Business                                        17%                        (d)

Net Income on Advisory                                                    $12.5 mm

 

Total Net Income                                                                 $44.5 mm

Implied ROE on Tangible Book Value                              16.8%

Implied ROE on Total Book Value                                     13.9%                     (e)

P/E using equity market cap                                               4.9x                         (f)

 

 

(a)     The $265 million of tangible book value is slightly lower than cash plus stock portfolio due to payables exceeding receivables by $2.2 million

(b)     The historical return on their prop portfolio is staggeringly high.  The return was 73% per year between 2002 and 2007 versus 24% for the S&P Metals & Mining and 16% for the S&P TSX Composite .  However, there was obviously a bull market tailwind.  The 12% return assumption includes the drag from the $49 million of idle cash.  I am assuming that over time they will find opportunities (as management indicates that they are now) and will run with less cash. 

(c)     The average EBITDA for the four years prior to the July 2007 closing of the transaction was $12.5 million.  In the fiscal years ending June 2006 and June 2007, the advisory EBITDA was $17.0 and $22.9 million, respectively.  In the 8 months from the time the deal closed to the end of the March quarter, EBITDA was $13.4 million, implying an annual run rate of $20 million.

(d)     The advisory business is truly, with capital raising and M&A advisory deals conducted all over the word.  The weighted average tax rate is approximately 17%.  As a reminder, the prop portfolio is based on Cayman and has no corporate tax.

(e)     Includes goodwill from the acquisition of the advisory business in July 2007.  Total March 31 book value $319 million.

(f)      Diluted market cap of $217 million (@ $5.75 stock price) divided by total net income of $44.5 million.

 

Finally, valuation support is aided by the 1.5 cent monthly dividend the company has been paying.  At the $5.75 stock price this equates to a 3.1% yield.  Management may increase the dividend depending on their ability to execute on the 2.8 million share buyback authorization (10% of float).  For the nine months ended March 31, 2008, 100,400 shares were repurchased at an average cost of CAD$7.93.  Management has indicated that the company is buying back stock aggressively but the current free fall in the shares has occurred largely during the blackout period ahead of the fiscal year end earnings release in early September.  Also,  the TSX restricts the company from buying back more than 13,500 shares per day based upon its relatively low trading volumes.

 

Risks

 

- Portfolio holdings could continue to decline making even the most conservative assumptions seem less so.

- The global resource sector could stagnate as far as M&A, capital raising and restructuring, reducing deal flow.

- Both the portfolio and advisory sides of the business produce lumpy, unpredictable returns.

- Departure of one or more bankers could hurt the business.  To date turnover has been low.
- The concentration of positions within the portfolio isn’t disclosed.  To the degree that concentration is high, the risks (and
   potential rewards) are magnified.

- The stock is illiquid.

 

Catalyst

- Fiscal fourth quarter should highlight gap between the stock price and tangible book value
- The company has an authorization in place to buy up to 2.8 million shares
- Management is frustrated with the stock and plans to increase visibility with the investment community.