Description

Recommending purchase of MFC Industrial

Key reasons for purchase

MFC Industrial is awaiting regulatory approval of an unidentified bank acquisition, which will supply a European banking license. With that banking license, MFC will be permitted to factor its customer accounts receivable, supplementing its existing trade finance and service business. MFC management has indicated they expect to receive all approvals by year end.

The banking initiative could provide attractive opportunities to invest the company’s substantial excess cash balances, more than doubling EBITDA and generating significant free cash flow. If successful, the company could easily generate more than $0.50 per share of free cash flow, more than double its current run rate, putting the current free cash flow yield well above 20%. In this scenario, the shares should rise substantially as the business’s earnings power became more apparent.

If the company cannot achieve adequate returns on its latest initiative, the stock trades below a conservative estimate of liquidation value. Large concentrated holders will likely push for a sale or orderly liquidation of the business if the current initiative is unsuccessful.

Terms have not been announced, but MFC management has indicated it is not making a major upfront capital outlay, rather it will invest significant equity capital for future factoring activity once it has obtained all approvals for the acquisition. Management expects final regulatory approval before year end. More details on the factoring initiative are below.

Given the stock and business’s long run of underperformance, I believe a majority of holders would back a reasonably priced transaction, assuming the company cannot meaningfully improve earnings. Based on conversations with management, I suspect they would also be open to a sale or liquidation in that scenario.

As a result, there is significant upside if the company’s factoring initiatives succeed, and limited downside from current prices if they don’t achieve scale. In addition I think the factoring initiative has a high probability of success, given it is a natural extension of the existing business and leverages existing customer relationships.

In brief there are at least three scenarios where a bet on MFC shares at current prices is profitable:

1) Factoring initiative works

2) Sale of company at premium

3) Natural gas and oil prices rebound

Two critical parts of the thesis here are the liquidation value analysis, and analysis of the factoring initiative.

Liquidation value analysis

Notes on Liquidation Analysis:

Cash, AR, and inventory discounts: Inventory is at cost, and accounts receivable have low historical bad debt incidence. I have discounted all three on the expectation that there would some cash that would be taxed on repatriation to US dollars, for example cash held in China and Europe, and that there would be some frictional costs on inventory liquidation and on AR collection.

In reality, I think the company would look for ways to liquidate with the fewest tax consequences, and believe a sale to a third party buyer or to its largest holder, IAT reinsurance (Peter Kellogg), followed by an orderly liquidation, would be the most likely outcome.

Assets for Sale (discontinued operations): This is primarily MFC’s energy business, which is primarily natural gas wells and reserves in Canada’s Western Sedimentary Basin. The company has wrote down these assets by $107 million in the most recent quarter (3Q15). The assets are on the books for $210 million, offset by $51 million of bank debt, $96 million decommissioning obligations, and $16 million of ‘other liabilities’. It’s important to note that likely buyers will not calculate decommissioning obligations at book, but will calculate a present value over the production life. This will likely result in a significantly lower decommissioning calculation for a buyer.

I have given the company almost no value for these assets in my liquidation scenario. Management has expressed a fair degree of confidence in recent conversations their estimates are realistic and possibly conservative. Given continued weakening of natural gas prices however, I think it’s appropriate to discount these for no value realization.

It is important to note however, that MFC is currently operating its energy properties at a modest cash flow loss. As such, it is not a forced seller, and if required, could hold the assets for a more opportune selling environment.

The only scenario I can see where these assets would actually represent a net liability is one in which natural gas prices remain non-economic for many years to come. If readers want to view this as the base case, I would suggest haircutting the expected asset value of $210 million, but also the $100 million decommissioning liability, which should be discounted to its present value, likely closer to $50 million. It’s hard for me to see a lot of downside from my current estimate after making that adjustment.

Assets for sale also include MFC’s leasehold interest in the Wabush Iron Ore mine, and its stake in the Pea Ridge mine. Given depressed iron ore prices, no value is ascribed to these assets. There is no associated debt with these assets however, so they represent a long term option on iron ore prices.

Equity Investments (China Eye Centers):A rarely mentioned success story for MFC, the majority of equity income comes from a chain of China based eye centers which perform cataract lens replacement and laser surgery vision correction. This business, in which MFC made a modest initial investment and owns a 50% stake, has steadily grown over the last few years. For the 9 months in 2015, MFC’s equity stake had generated $8.75 million, up 11% from a year ago. Distributions for the year from the venture to MFC were $6 million as of September 30.

Given MFC’s non-controlling position in this investment, combined with its location in China, which creates additional governance and cash mobility risk, I have applied only a six times multiple to the income stream from this business. I believe this is conservative, given the businesses’ growth profile.

Fesil Ferrosilicon production: In January 2014, MFC bought the Fesil Group, another supply chain management business, for $82 million, plus a two year payout based on certain production targets (roughly $3 million additional). Fesil’s most valuable asset was a ferrosilicon plant based in Norway. Ferrosilicon is an essential alloy used in the production of stainless steel. Ferrosilicon is produced to tight engineering specifications, making it less of a commodity than other parts of the steel supply chain. Pricing for the product has held improved somewhat since the time of purchase, with those gains being roughly offset by demand declines.

Annual capacity of the plant's two furnaces is approximately 80,000 MT of ferrosilicon and 23,000 MT of microsilica. Based on reported ferrosilicon market prices of $850 per ton, this implies revenue of $68 million for ferrosilicon, plus microsilica revenue, at reported prices of $200 per ton (limited data), implies an additional $5 million, for total revenue of $73 million.

In the liquidation analysis, I assume a liquidation price of 0.5x sales, or $38 million. This would appear to be consistent with the original Fesil purchase price of $85 million, assuming there was substantial excess working capital on hand (MFC did not disclose those details of the acquisition).

Factoring Initiative

Partly for regulatory reasons, MFC management has made very few disclosures on its banking plans, aside from indicating that factoring will likely be the largest use of capital. The following are my own interpretations based on management’s limited remarks, and on reviewing other public factors.

Presently, MFC generates more than $1 billion in revenue, but its mid-single digit gross margins barely cover the company’s fixed costs. The goal with the banking license is to leverage the substantial cash balances and infrastructure to generate additional return. Some of the company’s staff came from an earlier Smith vehicle, Mass Financial, and have direct experience with the kinds of businesses MFC is now targeting.

A sample transaction could look as follows – MFC today is a middleman between large European millers of wood chips, burned by individuals for home heating, and the distributors of those wood chips. MFC’s primary service here is accumulating large amounts of the chips in the off season, and then reselling them in winter. MFC’s vendor, the mill, then has a large receivable from the distributor, which it has to wait to collect. Ideally, the mill would like to factor this receivable, but wood chip distribution is a specialized niche, and in general the banks are not as familiar with smaller distributors as MFC is, having worked with these customers for many years.

Once licensed, MFC will factor the mills receivables. Inclusive of factoring fees, the effective rate on those transactions could approach 10%, however a portion of that fee will be paid to an credit insurer, reducing MFC’s from credit risk. I assume that net of credit insurance, MFC gets a 6% ROE on its factoring investment, with limited credit risk.

As a bank however, MFC will leverage its capital investment, likely by at least four to one, which would still leave it comparatively overcapitalized.

In theory the numbers could look as follows:

Equity investment: $100 million

Leverage: 4x, $400 million borrowed capital at 4%, borrow cost of $16 million.

Total loaned funds: $500 million

Expected annual return: $30 million (6% of $500 million), less interest, for $14 million net, a 14% ROI.

$14 million net represents incremental pretax earnings to MFC of $0.23 per share, and would roughly double the company’s current free cash flow.

In this example however, MFC has only deployed a third of its available cash on hand. Over time, I believe it could increase this investment, thereby growing the incremental earnings contribution.

Major Holders

Peter Kellogg, IAC Reinsurance: Kellogg, directly and through the reinsurer, IAC, owns 32.7% of shares outstanding. As part of a settlement following a contentious proxy battle launched by Kellogg in 2013 for board control, Kellogg has a standstill on share transactions until August of 2016. In exchange, Kellogg was given the position of chairman, resigning that position earlier this year.

Kellogg’s shares were purchased at prices mostly north of $6 per share, so he’s sitting on a substantial loss at present.

My sense is Kellogg is in the same ‘wait and see’ position as other shareholders as regards the factoring initiative. If that initiative is unsuccessful he will likely try to recoup part of his investment through some corporate action, either acquiring the business at a reasonable premium, utilizing the excess cash and gradually liquidating the most valuable parts, or selling to a higher bidder.

Lloyd Miller: Mr. Miller, a widely followed private investor, owns 7% of the outstanding shares.

Management owns roughly 2% of shares directly and roughly 2% of shares through options. CEO Gerardo Cortina owns 509,000 shares, representing 0.8% of outstanding shares. CFO Samuel Morrow bought 40,000 shares in open market transactions at an average price of around $3.40.

Float thus represents 55% of the outstanding 63 million share base, or roughly 35 million shares. Current market cap of tradable float is $70 million.

Share repurchase

MFC holds more than two times the current market cap in cash, but management has expressed skepticism it could repurchase sufficient quantities of shares in the open market to justify a repurchase. In addition, they have indicated a preference of reserving capital for the factoring initiative.

On the third quarter conference call management did open the door to a repurchase for what I think is the first time. Given limited liquidity, it is possible a repurchase would come in the form of a tender offer, possibly to small lot shareholders.

Earnings and Valuation

In addition, to the liquidation analysis, MFC looks fairly cheap on current EBITDA and free cash flow. Adjusted for a one time inventory adjustment in the third quarter, the company earned $7.5 million, in what tends to be one of the company’s slower quarters. For the nine months it earned $27.6 million from continuing operations. In conversations with management, they have indicated an $8 million run rate EBITDA is reasonable for the existing businesses, representing roughly $32 million in annual EBITDA.

On cash flow, the core MFC supply chain business is likely generating a couple million of cash profit on a modest GAAP operating loss. The difference between cash and GAAP is depreciation, as MFC has virtually no large cap ex requirements, and taxes, as the company has historically been adept at offsetting taxable income with losses in other parts of its businesses. In addition, MFC receives roughly $8 million of cash distributions from its equity investments, putting total free cash flow in the low teens. It is worth noting that the cash distributions from the China equity investment stay in China, given repatriation costs. Those cash levels are currently around 10% of MFC’s total cash holdings of $300 million.

Current EV/EBITDA

Net Debt: $298 million cash, less ST bank borrowings ($206 mil) less debt ($202) million, plus expected proceeds fourth quarter working capital reduction ($50 million): $60 million

Market Cap: $130 million.

Enterprise value: $190 million. EV/EBITDA: 5.9x.

Free cash flow (alternative calculation)

$32 million EBITDA

Less cash financing: $15 million

Less maintenance cap ex: $1 million

Less taxes: $3 million

Net free cash flow: $13 million

Current market cap/FCF: $130/$13 million = 10x

Thus even running at what is hopefully the operational low the stock does not look especially expensive on earnings. Once the company disposes of its discontinued operations, the EV ratios would improve further, and if management bought back some shares at these depressed prices it would be hugely accretive.

Note that the company finished its construction of an electrical plant fueled by its Niton gas production, which should add roughly $5 million of annual EBITDA. That said, there are so many puts and takes with MFC’s hodgepodge of businesses, those gains will likely be obscured by developments in its other businesses.

Key Risks

The biggest risk on liquidation value is on the assets held for sale, given $160 million of excluded liabilities on held for sale assets. That said, $100 million of this liability is decommissioning obligations, which does not take into account the time horizon of decommissioning costs. In addition, MFC’s holding costs on these assets is relatively low. I view the worst case scenario for assets held for sale as being simply a longer holding period, until resource prices improve.

On the banking initiative, there is considerable operational risk, given this is a greenfield initiative. However MFC has a long history with trade finance, and management is fundamentally cautious. I would expect that the more likely disappointment here is a failure to allocate sufficient capital, rather than an actual loss of capital.

Finally, it is entirely possible that progress on the banking initiative is offset by further erosion in the core supply chain business. That said, most of this business is variable cost, and there is little incentive for MFC to continue to service unprofitable business lines.

Further Background

MFC Industrial was formed in 2010 through the merger of MFC Financial, a merchant bank, and Terra Nova, which primarily collected an iron ore royalty on the Wabush mine in Newfoundland. Both were iterations of distressed investments made earlier by Michael Smith, who had had a fair amount of success up to that time buying and turning around distressed assets.

In 2012 MFC purchased Compton Petroleum from distressed sellers for $33 million. That investment generated very attractive returns until energy markets collapsed in late 2014.

More or less at the same time, iron ore prices collapsed, turning the company’s profitable iron ore royalty into an option on iron ore price recovery. Cliff, the operator of that mine, as abandoned the mine as part of a complete exit of Canada – MFC, the first leaseholder, is awaiting the Canadian bankruptcy process to retake full ownership. MFC contractually has the right to purchase Cliff’s mining equipment on the site at fair market value – it is not clear at this time whether the company will do so, given depressed ore prices.

Despite very attractive ROIs on Compton and Wabush over their holding periods, a substantial part of those returns were reinvested in expanding the company’s merchant bank into an part of part of those returns were reinvested in expanding the company’s merchant bank into an integrated materials procurement and logistics business, without producing satisfactory returns. The business procures and inventories metals, plastics, and wood chips, for manufacturers and distributors. This is a low margin business in the best of times, and has been hurt further by the recent steel industry downturn, as steel manufacturing represents an important end market for MFC’s metal procurement. Related to this, in 2014 MFC purchased the ferrosilicon and supply chain business Fesil for just over $80 million. Despite overall steel industry weakness, the ferrosilicon business has held up reasonably well, reflecting continued demand for stainless steel products.

MFC has committed to selling its energy assets, and has proceeds, net of debt and environmental reclamation expenses, of $45 million. Based on conversations with management, it appears even in this environment, this is a realistic expectation. Note that the amount is a significant write-down from the company’s prior expectations and original booked reserves on the asset, and is only slightly above the price paid by MFC itself in what at the time was a distressed asset purchase.

Catalyst

Factoring initiative, end of Kellogg standstill after August 2016.