Description

Kobex Capital Corp (KXM) is a Canadian shell company trading at a 23.6% discount to adjusted NAV (82.7% of which is net cash and the remainder of which is a liquid public equity), and an 18.5% discount to the price at which Kingsway Financial Services (KFS) has promised to commence an issuer bid if they are successful in reconstituting the board at a special meeting to be held in November.

This is a very simple idea suitable for personal accounts (including those belonging to 95 year old grandfathers!), and as such this will be a quick write-up designed primarily to call in the coordinates to VIC members who may be interested in this type of idea. All dollars are CAD.

I. NAV Calculation

KXM, currently trading at $0.53/share, has an adjusted NAV of $0.694/share, consisting of the following:

 Cash: $27,906,749

1,175,746 Common Shares of Mountain Province Mines (MD) @ CAD$4.15/share: $4,879,346

Options Proceeds (@ $0.65/share): $904,000

Total Assets: $33,732,363 

Onerous Lease Contract: $34,196

Accounts Payable/Accrued: $26,399

Provision for Incremental SG&A/activist defense: $1,000,000

Total Liabilities: $1,060,595

NAV: $32,671,768

Shares Outstanding: 47,081,387

NAV/Share: $0.694

II. Tax Assets

Additionally, KXM has off balance sheet Canadian tax loss carryforwards consisting of the following:

Capital Loss Carryforwards: $12,617,710
Income Loss Carryforwards: $21,002,651
Other Deductible Temporary Differences: $4,880,660

In order to realize any value from these tax assets, KXM will need to both own an operating business it can consolidate for tax purposes, and also generate capital gains -- neither of which it is currently doing. 

However, to put some rough numbers around what these tax assets could be worth in an upside case:

• Capital Loss Carryforwards: If $15 million of cash is used to generate 10% annual taxable gains, the capital loss carryforwards would be used up in ~9 years and would have an NPV of ~$1.7 million at a 10% discount rate.
• Income Loss Carryforwards: If the income loss carryforwards are used in a straight line over 10 years, they would carry an NPV of ~$3.8 million at a 10% discount rate. Realistically, I think the company could do better than that by buying $5 - $6 million of EBITDA for 6x-7x with a 50/50 capital structure.... but again, this is all just spreadsheet math/possible future upside
• Other Deductible Differences: I mark these at $0 as I do not know how/when they are reversed in Canada

In total, the tax assets could add ~$5.4 million to NAV, or $0.115/share, if the company is successful in generating both taxable income and capital gains. 

I would flag as a risk to the upside case that these tax assets could become impaired if KFS wins and the Canadian Revenue Agency (CRA) deems the new board composition as a de jure change of control. KFS has clearly chosen independent directors to avoid impairing the tax assets, but I could see the CRA wanting to take a closer look. 

III. Current Proxy Situation/Event Path

The incumbent directors of the company (who own very little stock) have had a couple of years to do something with the shell, and have only succeeded in making one investment -- in publicly traded Mountain Province Diamonds (NSDQ:MDM), a JV with the De Beers family in an early stage Canadian diamond mine project. I have no view on MDM other than to note that the name is sufficiently liquid that KXM shareholders can easily hedge out their implied long exposure to the name if inclined to do so.

In September, KFS bought a block of stock at $0.65 (current ownership is 14.87%) and requisitioned a special shareholder meeting to replace the board with five KFS-nominated independent directors. If elected, the nominees have a mandate from KFS to commence a share repurchase via issuer bid at $0.65/share. The filings do not quantify the total number of shares that would be eligible to be repurchased under such issuer bid.  The special meeting is scheduled for November 17.

On October 9, the incumbent directors installed shareholder rights plan with a 15% trigger. My personal view is that the pill is clearly designed to protect directors and will likely alienate shareholders, increasing the likelihood that KFS will be successful with its proxy contest.

On October 13, KFS directly launched a tender at $0.65/share for the greater of (i) the amount of shares they can purchase without triggering the pill (currently ~0.1% of total shares outstanding); or (ii) 19.9% (~5.1% of shares outstanding). So not a great deal of shares in either instance, but a strong message. In its letter of transmittal, KFS states that it “views the Rights Plan as oppressive. Kingsway expects to challenge the validity of the Rights Plan, or in the alternative, apply to have the Rights Plan cease-traded.” 

Worth mentioning is that Sprott Global Resource Investments is an 18% shareholder and will have significant influence on the ultimate outcome of the proxy. My guess is that they are (i) not sellers and (ii) supportive of KFS, given KFS’ higher likelihood of increasing NAV and realizing the value of the tax assets vs. the incumbent folks, who have done less than nothing.

If KFS is successful, I think investors at $0.53 will get quick partial liquidity at $0.65 from an issuer bid, and will then have a residual investment alongside KFS as they seek to realize the value of the tax assets and otherwise improve NAV/eliminate the discount. This strikes me as a compelling risk/reward given that it will be difficult for either the incumbent directors or the KFS nominees to impair NAV to the degree where a $0.53 cost basis loses money.

IV. Risks:

There are only three ways I can think of to permanently lose money here:

• Large capital losses generated by whomever is controlling capital allocation after Nov 17
• Abuse of passive shareholders via excessive comp or other related party transactions. I think this is a real risk regardless of the Nov 17 outcome, but investors at $0.53 have a wide margin of safety.
• Dissolution of company. This doesn't seem likely for a variety of reasons, but it is my understanding that Canada taxes foreign shareholders of dissolved companies as if they are receiving a dividend on the total amount distributed. So if you aren’t a Canadian resident and at some point in the future the company announces that it will dissolve, you will want to go ahead and sell your shares in the open market to somebody who is a Canadian resident.

Catalyst

Kingsway wins proxy contest on November 17 and new board commences tender offer at 22.6% premium to current market price