Description

Keweenaw Land Association (KEWL US EQUITY)

Executive Summary

For more than a decade, Keweenaw Land Association, Limited (“KEWL”) has been serially mismanaged by a management team and board more interested in company perks than driving shareholder value. In April, after a very ugly proxy fight, Cornwall Capital won 3 additional seats on the board. They own 26% of shares and now effectively control the company. They have owned the stock for over a decade, their board nominees are highly qualified to drive shareholder value, and we expect dramatic improvements in operating performance and shareholder communication. We expect a series of catalysts to unfold over the next 18 months driving significant shareholder value including: a) the company will convert to a REIT, which will provide significant strategic optionality for the company b) the company will monetize non-core assets and c) the company will be sold for a 30%-70% premium to the current price.

While this is not the highest potential return idea in our portfolio, it is among the highest risk-adjusted return ideas because downside risk is exceptionally low (buying a very safe asset at a discount to net asset value with incentivized owners) and there is material upside with several catalysts to drive value in the near-term (next 18 months).

Business Description/Background

Keweenaw is a leading forest products and land management company which owns and manages a portfolio consisting of 185,750 acres of primarily northern hardwoods timberland and 401,841 acres of both severed and attached mineral rights located primarily in the Upper Peninsula of Michigan.

Keys to the Thesis

·         The vast majority of KEWL’s asset value is in its land/timber. Timber is a safe and attractive asset class.

o   Both the land and the timber tend to appreciate at ~MSD real rates/annum with low correlation to other assets

o   Acts as a hedge against inflation

o   Physical asset with limited supply

§  We don’t pretend to be timber experts, but it should not be too controversial to say that KEWL is a safe asset. If the market tanks, this is a pretty safe place to have parked your money.

§  It is worth adding that KEWL’s location in upper Michigan means there is almost zero risk of forest fire or natural disaster affecting the timber value.

·         KEWL was serially mismanaged for decades.

o   KEWL board expenses were an egregious ~5.4% of total revenue in 2017 compared to peers which are all <1%.

o   KEWL has massively underperformed every timber comparable and ETF over the last 10 years. While the relevant indices and comparable companies are all up over 100% over that timeframe, KEWL has declined.

§  Last 10 years: total return/annual return

·         KEWL US EQUITY: -6.65%/ -.69%

·         WOOD US EQUITY: 111.71%/ 7.89%

·         ADN CN EQUITY: 168.32%/ 10.52%

·         PCH US EQUITY: 102.07%/ 7.39%

·         POPE US EQUITY: 211.21%/ 12.19%

o   KEWL’s 2017 EBITDA margin was ~1/3 of even the bottom end of their comparable set (based on 2017 results)

§  KEWL: 9%

§  Acadian Timber 26%

§  Catchmark Timber: 28%

§  Potlatch: 39%

§  Pope Resources: 44%

o   KEWL’s previous board did everything they could to prevent shareholders from realizing full value and to entrench their position

§  KEWL pulled forward its 2018 record date and annual meeting by more than a month to limit shareholder communication

§  In the event Cornwall’s three nominees were not elected to the board, Jamie Mai would have been required to resign from the board immediately.

§  Perhaps most egregiously, the previous board’s estimate of timber inventory was off by more than 25%. When you run a company and your primary asset is timber, you need to be closer than that.

·         We spoke to a Forestry expert who said that any estimate off by more than 5% would “raise eyebrows.”

·         KEWL’s current board, controlled by Cornwall Capital, is well-qualified and incentivized to drive shareholder value. The company has gone from a D- board to an A+ board.

o   Cornwall Capital, an investment firm with ~$500M in assets, has produced attractive long-term returns for investors and was profiled in the “Big Short” as one of the funds that made a tremendous profit during the financial crisis.

o   Cornwall Capital owns ~26% of shares. They have owned shares for more than a decade. They recently waged a very ugly proxy fight against KEWL’s prior board.

o   Cornwall won 3 additional board seats in the April vote, effectively giving Cornwall Capital control of the board. The board members bring the necessary skills (operational and private equity experience, pulp M&A experience, and small-cap board experience among others).

§  Ian Haft

·         Managing partners and CEO of Surgis Capital LLC. Previously worked at Cornwall Capital Management from 2009 until 2017. Prior to Cornwall Capita, worked at a middle-market PE firm, Boston Consulting Group, and The Blackstone Group. Graduated magna cum laude from Dartmouth and received his JD and MBA from Columbia.

§  Steve Winch

·         Currently managing partner of Villard Capital, a financial advisory firm partnering with both Fortune 150 and private equity firms. Recently served as a restructuring advisor for a leading industrial natural resources company. Previously, Mr. Winch was a Managing Director at The Blackstone Group focused on special situations investing. Before Blackstone, Mr. Winch was a senior advisor to Cornwall Capital Management. Prior to that, Mr. Winch was an engagement manager at McKinsey & company. He began his career in the Mergers & Acquisitions group of Salomon Brothers Inc. executing transactions in the pulp and paper and automotive industries, among others. Mr. Winch received a B.A. from Duke University, where he graduated magna cum laude and was elected Phi Beta Kappa, as well as an M.B.A with Distinction from Harvard Business School.

§  Paul Sonkin

·         Paul D. Sonkin was an analyst and portfolio manager at GAMCO Investors/Gabelli Funds. He was co-Portfolio Manager of the TETON Westwood Mighty Mites Fund, a value fund which primarily invests in micro-cap equity securities (“TETON Fund”). Mr. Sonkin has over 25 years of experience researching small, micro and nano-cap companies. Prior to analyzing stubs, spinoffs and micro-cap companies for GAMCO, Mr. Sonkin was for 14 years the portfolio manager of The Hummingbird Value Fund and the Tarsier Nanocap Value Fund. He holds an M.B.A. from Columbia Business School and a B.A. in Economics from Adelphi University. For 16 years, Mr. Sonkin was an adjunct professor at Columbia Business School, where he taught courses on security analysis and value investing. For over ten years, he was a member of the Executive Advisory Board of The HeilbrunnCenter for Graham & Dodd Investing at Columbia Business School.

·         Likely event path from here

o   First, KEWL’s current board will clean up the operations of the company. They have outlined a credible four-point plan:

§  Reposition the company for cash flow growth

·         Increase harvest rates

·         Align compensation of existing management and employees with long-term objectives

§  Reduce Operating Expenses

·         Eliminate Chairman’s salary and reduce other non-essential board expenses.

·         Conduct an overhead cost review given poor current position versus peers

§  Redesign Corporate Governance for the benefit of Shareholders

·         Eliminate staggered board and remove supermajority provisions

·         Conduct review of, and implement, other Board best practices

·         Improved disclosure of timber inventory

·         Regular communication with shareholders

§  Balance Sheet Repair

·         Cease all value destructive acquisitions

·         Focus on paying down debt

·         Monetize non-core assets, including property for sale, investment securities portfolio, among others

o   Second, KEWL will start aggressively monetizing non-core assets

§  The company has 185,750 acres of land, but portions of this land have much more valuable use than traditional timberland. In particular, there is i) waterfront land which is valuable for residential or recreational use and ii) commercial land.

·         Waterfront and commercial land sell for many multiples/acre than timberland.

o   Third, KEWL will become a REIT and upgrade to a national exchange.

§  The company has already filed the paperwork to become a REIT. We are told that it should be effective for the 2018 calendar year.

§  We also think the company will uplist to a better exchange.

·         A REIT conversion and better exchange will improve liquidity and significantly increases the number of options KEWL’s board has to monetize full value for shareholders.

§  Once this is complete, KEWL will have a more natural buying base.

·         REITS and timber companies will have to buy it as part of the index. This will likely create significant buying pressure as there are few natural sellers as shares are fairly closely held.

o   Once Cornwall has cleaned up operations, improved governance, and started to sell off non-core assets, they will proceed to the fourth step: selling the company (in some form or fashion).

§  It took Cornwall years to acquire their 26% position. Their stake is currently worth ~$36M. With a stock that currently only trades ~$100K/day. We do not think Cornwall can feasibly exit their position without a sale of the company.

o   A sale makes a lot of sense

§  A local player could absorb KEWL and significantly reduce overhead expenses. KEWL is one of the largest landowners in Michigan and we think many buyers would be interested.

§  The previous board tried to use KEWL’s low tax basis as an excuse for not being able to get a deal done. We think the board was not negotiating in good faith for the benefit of shareholders and that there are several ways to get a deal done without a large tax impact.

·         For example, once KEWL is a REIT and listed on a better exchange, we think there are several timber management companies that would be interested in a reverse merger.

·         KEWL could be turned into a shell company that only receives royalty on all timber sales and mineral royalties, avoiding an outright sale but effectively transferring all production to another company.

o   There are a lot of creative ways to eliminate or at least minimize any tax hit. Cornwall Capital built their firm on figuring out options and exploiting them. We have a high degree confidence that they will be able to realize fair value for shareholders.

o   Finally, as part of a sale consideration, or in the event KEWL decides to remain an independent entity, there could be valuable carbon offsets that were not at all explored by the previous management company.

§  We will avoid getting into the weeds of California’s cap and trade system, but at a high level, certain forestry projects are eligible for carbon offset credits if they are more carbon friendly (less harvesting than average, more carbon emissions saved through tree growth) than the baseline average for their given region.

§  We have been told by experts that while the previous board’s flawed estimate of timber inventory would not have been an economically worthwhile carbon offset project, now that there is actually ~25% more inventory than they originally thought, there could be meaningful value in exploring this path. We are told potential value could be in the ~$15M NPV range.

·         We are not experts in this area and are relying on expert’s opinions. We use this value only in a bull case.

Valuation

Important Valuation Notes

·         As evident in the table above, we think KEWL is very low risk. Of course, we could construct a scenario with more downside, but it would require some creativity. Realistically, we think the bear case is we have dead money for a while.

·         For the mineral rights, the previous board published the value was worth ~$30M in undiscounted cash flows. Highland Copper is breaking ground in 2H of this year.

o   It is possible the company’s $30M estimate proves conservative but it is not the bet we are making here

·         For the value/acre of the main fee timberland, we triangulated several different sources to arrive at our low, base, and upside cases.

o   On the low end, we use the 12/31/2016 appraisal value. We think this is conservative because timber end markets have been strong since 12/31/2016 and the previous board’s internal assessment of timber inventory was proven to be materially low. Moreover, the previous board and the appraiser had incentives to lowball this number.

o   Since 2010, KEWL has purchased 8,351 acres at an average price of $954/acre.

§  Note this is also a bit of a stale number since it is from the 12/31/2016 assessment.

o   Since 2010, KEWL has sold 1,607 acres at an average price of $1,521/acre.

§  It is important to note that some of these sales were sold for “higher and better use.” The company does not provide the exact breakout.

o   Experts we have spoken to have suggested that $1,000/acre is a reasonable to conservative assessment of the main timberland. The arguably conservative $901 12/31/2016 assessment, the strength in timber markets over the last ~18 months, and natural growth of their inventory during a period of under-harvesting serve as supporting data points.

·         For the value/acre of the waterfront land, we compiled 25 different current listings of KEWL property for sale. Areas include: Lake Superior Cove, Isaccson Lake, West Merriman, Paint River Highlands, Norway Bluff Estates, and Michigamme River Lots.

o   In total, the 25 listings comprise 98.3 acres at a price/acre of $16,210.

o   Experts we have spoken to have suggested that the previous board was not nearly aggressive enough in listing and marketing these properties and that there is easily 500 acres of land in this premium category.

o   We assume a low, base, and upside case/acre for the estimates 500 acres of waterfront land to be: $10,000, $12,500, and $15,000.

·         For the estimated 2,500 acres in commercial land, we use low, base, and upside cases of $1,500, $2,400 and $3,000/acre respectively.

o   This is consistent with large acreage publicly listed land sales in both the Keweenaw (non-company owned land) and surrounding regions for commercial purposes.

·         We assume that Cornwall Capital can structure the main timberland sale in a tax-efficient manner (reverse merger, stock for stock deal, etc). We assume that the commercial, waterfront, and remaining land are sold at a cost basis of zero and the company pays a 21% tax rate on 100% of the sale.

Risks

·         The company may not find willing buyers or be able to structure the deal in a way that is tax efficient.

o   In this scenario, we STILL think shareholders would likely come out o.k. as the company could increase harvesting, reduce operating expenses, and potentially monetize carbon offsets.

·         Timber prices and associated timberland could decline

Conclusion

This is a very simple idea, which is one of the reasons we really like it. It is very difficult to construct a scenario in which you lose money over the next three years. We think downside is basically dead money, which we see as very unlikely given the motivation of the current controlling shareholder to monetize a 10-year lousy investment for which it has no real liquidity options other than an outright sale. Cornwall Capital has put a significant “reputation bet” behind this investment. They have spent over a decade on this investment, have assumed control of the board in an ugly proxy fight, and now it is time to deliver. We have faith that the new board has the skills required to close the gap to intrinsic value.

Catalyst

• REIT conversion in 2018
• Improved financials from increased harvesting and reduced operating expenses
• Uplisting to a better exchange
• Monetization of mineral rights
• Sale of company in next ~18 months