Description

MFC Industrial (MIL)-  LONG

[note:  this write-up will endeavor to avoid the following clichés:  “assymetric upside;” “compelling investment opportunity;” “paid while you wait.”]

The name “Michael J. Smith” is likely familiar to many on VIC.  A number of Smith’s previous entities have appeared here—namely, Terra Nova Royalty (Francisco432, Sept. 2010); Mass Financial (zeke375, August 2010); and KHD (multiple write-ups).    I think it’s an opportune time to revisit the unorthodox Mr. Smith and his latest entity, MFC Industrial (NYSE: MIL).   Here’s a summary of the bullish argument:

• Trades at ~70% of tangible book
• Significant recent insider buying (600,000+ shares) in July / August 2013 by billionaire Peter Kellogg (33% owner of MIL through his personal stake and that of his reinsurance vehicle), who has invested repeatedly in entities run by Smith
• In September of 2012, MIL purchased a distressed Canadian natural gas company, Compton Petroleum, at the (near-term) bottom of the market for $33 million in cash plus assumption of debt 
• Compton, with a) proved reserves of 24mmboe, b) facilities that Smith recently pegged at $50 - $60 million in value,  and c) a land bank of c. 294,000 net acres, arguably justifies a major chunk of MIL’s enterprise value (c. $400 million as of this writing) on its own
• Wabush iron ore royalty stream (inherited from predecessor Terra Nova) adds $150 - 225 million in value, depending on long term ore pricing and contract adjustment assumptions (MIL’s rights extend to 2055)
• Commodities trading / merchant banking operation (formerly Mass Financial, merged into MIL in 2010) suffers from (extremely) poor disclosure, but traded for $200+ million just prior to merger; business has subsequently grown through acquisition of majority interests in ACCR and Possehl
• Has the balance sheet to ride out cyclicality:  c. $320 million of cash (~$5 per share), c. $195 million debt at corporate level
• Proven moneymaker in Michael J. Smith: 15 – 20% annual compounded increase in book value of Smith’s entities over the long term; track record of purchasing distressed assets and utilizing spin-offs to realize value
• Dividend policy:  Annually pegged at Dow Jones yield +0.25% (total dividend for 2013 will be $0.24/share, paid quarterly; yield of 2.9% on share price of $8.17)

A Bit of History:  Michael J. Smith

Although Smith’s career as an executive began in the 1980s, his story became more interesting in 1996, when Arbatax was spun off from a paper/pulp company called Mercer.   The 1996 spinoff began a long series of transactions that ultimately resulted in MFC Industrial.  A complete history would consume multiple pages, but I would refer you to Tobiac Capital’s excellent summary and graphic,  linked below (give it a chance—I’d be the first to admit that the analysis on this site is typically lightweight, to be charitable):  

http://seekingalpha.com/article/290755-15-for-15-years-michael-j-smiths-outstanding-track-record

Note that MIL’s own Company Overview (corporate Website) cites a 20.4% compounded annual return over the past 10 years.

I will be the first to say that I’m not impressed with a long list of entities, name changes, “wheeling and dealing,” etc.; on the contrary, it’s often an indicator of malfeasance.  Accordingly, in the case of MIL, I count it as risk factor, somewhat mitigated by the length of Smith’s public track record, and Kellogg’s involvement throughout (see “Shareholder Base,” below).   Looking at the record over the past 17 years, however, I believe it’s motivated by an intense drive to lawfully minimize taxes (a la John Malone), as well as a keen awareness of conglomerate discounts and tactics to eradicate those discounts.   We’ve all witnessed the growing prominence of spin-offs in the recent past; for Smith, spinouts are an established modus operandi as opposed to a passing phase.  In Smith’s history, I count 6 spin-offs since 1996.  I would venture to say that it’s a matter of when, rather than if, the next spin-off occurs.

MFC in its current form

At present, MFC Industrial consists of the following pieces:

• Wabush Iron Ore royalty
• Compton Petroleum
• Former Mass Financial (commodities supply chain operation & merchant banking)
• Other (smaller) projects-  Pea Ridge iron mine, Cobalt operation, etc.  (I will not focus on these)

Wabush Iron Ore Royalty

The Wabush royalty is a stream of income derived from the Scully iron mine in Newfoundland.   True to form, Smith bought the royalty in a distressed situation a number of years ago (note the trend of pursuing distressed commodity plays).  In any event, MIL owns a sub-lease to the property through 2055; MIL’s only direct cost is the small lease payment on the master.  The mine was initially operated jointly by Cleveland-Cliffs (“Cliffs”), Arcelor Mittal, and a subsidiary of US Steel; Cliffs subsequently bought out its partners, and now serves as the sole operator.  As of 12/31/12, proven reserves were 186.2 mm tons, with an additional 22.8 mm tons probable @ ~35% Fe.  In 2012, Cliffs produced 3.2 million tons, or just under 11% of its company-wide iron ore production, from the Wabush mine.  The tonnage yielded a total 2012 royalty (paid quarterly) of $29.1 million.  In 2011, MIL realized royalties of $30.8 million from tonnage of just under 3.5 million.   Please note that MIL is subject to a 20% Canadian resource tax on this royalty.

Francisco432’s 2010 write-up of Terra Nova Royalty (MFC Industrial’s predecessor company) is very detailed with respect to the Wabush mine; it’s well worth your time if you pursue the MIL idea.

A few comments here.  First, MIL’s position as lessor obviously poses both an opportunity and a risk.  I like the fact that MIL is in the business of collecting royalties here, rather than the business of mine operations (generally speaking, mining has been a minefield for value investors).  I’m happy to have Cliffs incur the risks and hefty capex associated with the mine.  On the other hand, while MIL is guaranteed a (paltry) minimum annual royalty from Cliffs (c. $3.2 million), MIL’s fate in terms of production volume is entirely in Cliffs’ hands.

Several other risks are worthy of mention.  First, MIL and Cliffs have not historically seen eye to eye on the specifics of the royalty.  Essentially, the contract provides for an increase of the royalty under certain conditions surrounding benchmark pricing; to skip to the punchline, MIL filed suit against Cliffs and was awarded $11+ million through arbitration.   The parties continue to haggle, and while I view MIL as the aggressor, the rocky relationship is clearly a risk.

Second, one could reasonably argue that iron ore prices, at an average of $136 per ton in 2013, are at the high end of their historical range.   I attempt to account for this in my royalty assumptions when valuing the Wabush component.

Finally, Wabush, while a significant component of Cliffs’ ore production, is a higher cost (albeit profitable) mine for CLF.  The table below shows the declining trend of production in the mine over the past several years.  I will make the point that although Wabush is a higher cost mine for Cliffs, its geography in Newfoundland lends itself more easily to export than a number of competing mines.

Of more than passing concern is the decline in 1H13 production (857,000 tons shipped YTD 6/30/13, vs. 1.394 million 1H 2012), but Cliffs has publicly maintained that it expects to ship more than 3.0 million tons by the end of the year.  In conference calls, Smith said that he derives comfort from the level of ore inventories on the ground at the moment.

Valuation of the Wabush Mine Royalty:  I assume production of 3 million tons per year, resulting in a production period of 21 – 22 years (if the cash flows are realized earlier, so much the better).  To arrive at valuation, I consider royalty levels of $29 million, $25 million, and $20 million, utilizing a discount rate of 10%.  At royalties of $29 million per year, the result is a (gross, pre-resource tax) value of $275 million.  If instead we assume $25 million per year, the value drops to $237 million.   At $20 million per year, the value is $190 million, which I believe roughly approximates the carried value of the assets on MIL’s balance sheet.

Compton Petroleum

Compton Petroleum, a natural gas (84% of reserves) producer based in Alberta, was a stand-alone public entity traded on the Toronto exchange prior to acquisition by MIL in September of 2012.  The company is focused on the Western Canada Sedimentary Basin, specifically in the Deep Basin portion. 

At 12/31/12 (see MIL’s form 20-F exhibit), using SEC methodology, Compton had 24 mmboe net proved reserves (37 mmboe net proved and probable).   Note that under Canadian methodology (forward pricing) a year earlier, the same independent estimator pegged Compton’s  reserves at 41.5 mmboe proved, and 62.1 mmboe proved & probable.   The company ended 2012 with average production of about 56,000 mcf per day of gas, and 10,812 boe of liquids per day.  Development and production assets were $503 million, with a book value of $228 million.  Importantly, Compton has a land bank of c. 294,000 net acres; also, the company has processing facilities that Smith valued at $50 to $60 million in a recent conference call.

Smith used $33 million of cash to purchase Compton for $1.25 per share, along with assumption of debt.   For reference, Compton traded at $4 in April of 2012, and at $7 in October of 2011.  Major shareholders as of early 2012 included TPG Opportunities Advisors, Barclays, Davidson Kempner Partners, and Monarch Alternative Capital.  After closing the deal in September of 2012, MFC recognized a gain of $244 million on negative goodwill from the purchase, which accounts for the distorted P/E ratios in the popular databases.

So the obvious question is… why so cheap?   First, I think you have to give Smith credit for timing the purchase; gas prices reached their (near term?) nadir in the summer of 2012; Smith saw an opportunity and jumped on it.  Importantly, Compton’s balance sheet was a bit of a mess at the time, and G&A expense was high.  Although the company touted 81% reduction of debt following the financial crisis in its annual report (March 2012), it left long term assets matched with a $127 million dollar current liability in the form of an overdrawn credit facility.  Smith provided a much-needed infusion of equity capital to defuse the liquidity crisis.

But there’s no doubt that the Alberta gas market faces headwinds; there’s no free lunch here, and there’s no shortage of challenges.  In 2006-7, almost 16,000 gas wells were drilled in the province; in 2013, that number is unlikely to break 1,000.  Province-wide production has declined from 14 billion cf/ day to 10 billion cf/ day at present.  The first LNG projects (Kitimat, LNG Canada, and Pacific Northwest LNG) are focused on British Columbia due to cost considerations.  Meanwhile, the Marcellus and other other US discoveries have put a dent in Alberta’s traditional export markets.  On the positive side, Mike Ekelund, the Assistant Deputy Minister at Alberta Energy, has been vocal about the province’s desire to work with British Columbia to enable easier export, and Alberta has a significant petrochemical base.  

Smith has big plans for Compton, so it makes sense to get comfortable with it; on the latest conference call, he announced plans to invest $220 million in additional midstream capabilities, joining forces with a yet-to-be-named partner (following excerpt is from Smith’s 6/30/13 letter):

This obviously is a risk or an opportunity, depending on one’s view of Smith’s ability to intelligently allocate capital, and one’s medium term view of the gas market in Alberta.

One final highlight of the Compton purchase is that it brought the company NOLs of c. $495 million, as of the time of acquisition (see 9/12/12 press release) —note that the balance sheet shows $19.6 million of deferred tax assets, vs.$6.9 million of liabilities.

Valuation for the Compton piece is more art than science.  Reasonable comps include Perpetual Energy (PMT.TO) and NuVista (NVA.TO), both of which are focused on E&P in Alberta, and have reserves heavily weighted toward gas.  Both are less than $1BB in enterprise value, and both generated net losses in 2Q13.  At the time of this writing, PMT.TO trades at a lower multiple of EV/ proved reserves (8.2X) and EV/ barrel produced, and as a reminder, Compton had c. 24mm boe at time of acquisition.  I hesitate to draw a firm conclusion from this—these are not perfect comps, the land holdings and facilities vary, and it’s a long way from the ground to the bank account.  But what we can say is that two very small, Alberta-focused, gas-heavy E&P companies  (52mm boe and 62mm boe in latest annual reports), both losing money, are trading at enterprise values of $500 million (PMT.TO) and $900 million (NVA.TO).  I’m not trying to distort the value of Compton here—a) I’ve not done detailed due diligence on PMT or NVA, and b) refer to caveats about challenges of the Alberta gas market, above---  but that gives me some comfort with respect to Smith’s c. $190MM EV acquisition of Compton (including assumption of $154mm of debt)… warts and industry headwinds included.  I would also note that neither Perpetual nor NuVista (both net debtors) carry the cash cushion of MIL -- not a bad thing to have in a capital intensive, commodity business.

Former Mass Financial Piece

This is the former Mass Financial Corporation (I’ll refer to this piece as “Mass”) that Smith, who ran both entities, folded into Terra Nova to create MIL in 2010.  “Mass” is Smith’s commodity trading outfit/ merchant bank.  The following business overview is excerpted from Terra Nova’s F-4 filed in 2010, at the time of the merger (again, note the “distressed” theme):

Mass is an integrated commodities and financial services company. It conducts its operations internationally. Mass’s activities include the supply and sales of commodities, proprietary investing and financial services.

          Mass’s integrated commodity operations are principally for its own account. Mass conducts trading primarily through its subsidiaries based in Vienna, Austria. Mass currently trades with commodity and other producers who are unable to execute sales effectively because of credit or currency issues affecting them or their principal customers. Mass supplies various commodities to its customers, including plastics, iron ore and aluminum. Such commodities originate either from Mass’s directly or indirectly held interests in natural resource projects or are secured by Mass from third parties.

          Mass often purchases the underlying commodity and resells it to an end buyer. Further, commodity producers and end customers often work with Mass to better manage their internal supply, distribution risk, and currency and capital requirements. These activities have allowed Mass to develop ongoing relationships with commodity producers, end customers and financiers and integrate them into their financial activities.

          Mass supplies a range of commodities and raw materials to industrial consumers. Its commercial counterparts are both producers and industrial consumers. Mass’s role is to be a reliable and competitive partner to businesses in the segments of the commodities market which it serves.

          Mass’s proprietary investing and financial services business focus on specialized financial services and corporate finance services. In particular, Mass focuses on meeting the financial needs of small to mid-sized companies and other business enterprises primarily in Europe and Asia, as well as assisting clients in capital raising and the execution of transactions that advance their strategic goals. Mass also commits its own capital to promising enterprises.

          Mass considers investment opportunities where: (i) its existing participation in the marketing and production of commodities provides expert insight; (ii) it can obtain a satisfactory return of future capital investment; and (iii) such investment integrates with Mass’s business.

          Mass’s philosophy is to utilize its financial strength to realize the commercial potential of assets in markets where it has a comprehensive understanding of the drivers of value.

          Additionally, Mass generates fee income by acting as an arranger and/or provider of bridge or interim financing to business enterprises pending reorganization. In furtherance of such services, Mass often restructures enterprises that are undergoing financial distress.

The income statement is lumpy, due in part to Mass’s principal investments.  Smith regularly steers investors toward book value ($215 million at 6/30/10, Mass’s last stand-alone financials) as the best way to gauge value.

Here’s how zeke375 laid it out in August of 2010:

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Whatever it is MFC does, it apparently does it extraordinarily well. Net revenues were $406.4 million, and the company reported net income for the full year 2009 of $75.2 million, or $2.70 per share, and a 65% return on equity.  The company pays virtually no income taxes due to its Barbados domicile anyway, and in 2009 actually booked a small tax recovery.  Operating cash flow was equally as impressive: $77.7 million, with cap-ex of $2.7 million.  Add in $5 million in distributions from its various joint ventures, and FCF at the MFC level was a cool $80 million. In reviewing the source of the company's income, MFC divulges the following [2009] revenue breakdown:

Commodities                                       $ 191.3

Trade / financial services                      $ 113.9

Interest and dividends                          $  14.4

Securities/ investment property              $  10.1

JV Equity Income                                 $    3.6

Other*                                               $   57.7

TOTAL                                               $  406.4

* Other income for 2009 includes a $49.1 million gain on the extinguishment of debt securities repurchased from KHD. (emphasis is salvo880’s)

While 2009 was a very good year for MFC, the company has done well every year since its separation from KHD.  MFC reported 2008 revenue of $598.8 million, with net income of $23.3 million, or $0.99 per share. In 2007, MFC did $543.9 million in revenue, with net income of $48.5 million, or $2.09 per share. The company has produced an outstanding ROE on a historical basis - 65% in 2009, 28.5% even in the tough 2008 year, and over 100% in 2007.  MFC has also accomplished this feat without anything like the typical investment banking leverage - MFC ended 2009 with a debt to equity ratio of only 0.28.

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I would highlight the fact that 2009 net income was distorted by the gain on extinguishment of debt.  Adjusting for this, it’s still a decent result on c. $210 million of equity, particularly given the business climate in 2009. 

For the 6 months ending 6/30/2010 (the end of Mass’s stint as a stand-alone public company), the company generated $174 million in sales, with an operating profit of $14 million.    

Fast forward to 2013.   Smith does not give us a revenue breakdown (let alone EBIT, etc.) for the major pieces that I’ve laid out in this write-up—this is the challenge of dealing with a Smith-run entity.   We can infer a rough revenue breakdown from the most recent stand-alone financials.  In 2012, Compton was running at an annualized rate of c.  $100 million per year as of 6/30/12.  At 6/30/13, MFC was running at an annualized revenue rate of about $750 million , and annualized operating income of $34 million (oversimplified extrapolation, not factoring in seasonality).   After accounting for the Wabush royalty, I would infer that the commodity trading/logistics/ finance operation (Mass) now accounts for about $600 million in annualized sales.  

Note that Mass’s sales ran at $406 million at 2009, so there’s a gap of $200 million there.  In addition to the bounce-back from the crisis environment of 2009, the $600 million inferred run rate reflects MIL’s acquisition of a majority interest in New Jersey based ACCR and its affiliate, Mexico City-based Possehl, late in 2012.   In his November, 2012 press release, Smith reports $113 million of assets and $73 million of liabilities for the acquired entities, but does not give us revenue or profit numbers.

My conclusions on the Mass piece:   1)  roughly $600 million in revenue;  2) historically attractive returns on capital;  3) resilient in a recessionary environment;  4) however, subject to very lumpy profitability (note the asterisk item in zeke375’s excerpt, above);  5) following acquisitions in 2012, somewhere on the order of $250 million in shareholder equity.

Other Notable Assets

MIL has several other assets that are not central to the investment thesis;  given the relatively small size, I will not focus on them here: 

• Pea Ridge Iron Mine in Missouri (mine is not in operation; currently in analysis / investigation phase)
• Hydroelectric power station and cobalt tailings project (Uganda)

Also, I should note one recent investment failure.  The company invested in an iron mine in India, only to witness a state-wide ban on mining activities  in Goa.  The investment—on the order of $50 million—was written off in the past year, and MIL has no further obligations or liabilities associated with the project.

Shareholder Base

My interest in MIL was rekindled by a 13D filing by Peter R. Kellogg on August 23, 2013.  As you may know, Kellogg led his family firm, Speer, Leeds & Kellogg, from the 1980s until its sale to Goldman in 2000 for a reported $6.5 billion.  Kellogg is a long-time investor in Smith entities; the earliest readily available public filings show that he invested in MFC Bancorp in August of 1999.  So this is someone that has stuck with Michael Smith through the twists and turns of multiple name changes, spinouts, mergers, new entities, and auditor changes over the past 14 years.  As of the latest filing, he and his re-insurance entity, IAT, in aggregate own 33.3% (20.825 million shares) of MIL’s common.  Kellogg disclaims beneficial interest in the IAT holdings (13.825 million); he and his wife own the remaining 7 million shares.  So I was motivated to re-visit the stock when I saw that Kellogg increased his personal stake by more than 500,000 shares at prices ranging from $8.22 - $8.82.  While I find that purchase interesting, I was frankly more interested to learn that Kellogg has continued to invest with Smith through thick and thin since 1999. 

 According to the 20-F, Michael Smith owns 273,000 common shares and 390,000 options.   Given Smith’s track record and reasonable cash comp (see below), this frankly strikes me as unreasonably low.   I therefore posed the question directly to the company—what about related entities, trusts, family relationships, or indirect ownership through other entities that hold the common (e.g., Kellogg entities)?   I received a vague answer:  “Mr. Smith’s family members do own shares; however, I do not know the exact amount nor the structure under which those shares are held.”  [Which leads me to an open question for Mr. Smith… why would you not fully disclose the holdings of any and all family members, family trusts, etc.?  Wouldn’t this lend some comfort to new investors, particularly given your aversion to disclosure of detailed financial metrics with respect to your operating divisions?]

While we’re on the subject of management, I’ll note that the conflict of interest from the past (Smith leading more than one public company) noted by others on VIC is no longer an issue.

Balance Sheet

As I point out elsewhere in this document, I’m critical of Smith’s poor disclosure of segment financial performance—for example, the former Mass business, Compton, and the Wabush royalty are lumped together in a single category.   If you’re new to MIL, you’ll find that Smith does provide a detailed written update every six months or so; in that update, Smith’s focus on the balance sheet is readily apparent.  As of 6/30/13, the highlights are as follows:  $319 million in cash; $195 million in debt (7 year term @ 2.4%); $174 million in additional short-term bank borrowings.  Smith does not consider the ST borrowings to be corporate debt, and points out that they are used to enable its commodities trading operations.  Borrowings against a $121 million, non-recourse A/R factoring facility, for example, are included in this number.  I would add that MIL’s inventories + A/R at 6/30 amounted to over $200 million.  Also worthy of note is that the company’s total aggregate credit facility limit is $463 million.  An additional liability is $115 million of de-commissioning liabilities—the company’s long term estimate of costs associated with putting Compton in mothballs. 

Smith clearly believes (and repeatedly states) that MIL should be valued on the basis of its net assets, along the lines of Leucadia and Berkshire.  Book value per share at 6/30/13 was $11.90 per share—note that there are no intangibles.   Turning to the asset side of the balance sheet, at 6/30 MIL had about $700 million of current assets, predominately in cash, receivables, and inventories.  Among the $650 million of long term assets, PP&E (predominately Compton facilities) is on the books at $78 million.  For potential upside, I would focus on 1) Interests in Resource Properties ($349 million), which consists of the Wabush royalty (marked up to $200 million in 2010) and Compton’s proved reserves; 2) Hydrocarbon probable reserves ($94 million); and Hydrocarbon Unproved Lands ($45 million), which consists of Compton’s 294 million net acre land bank. 

Income Statement

Given my view of MIL as an asset play, I will not spend much time on this.   Due to the lumpiness of earnings and principal investment activities, I don’t think it makes sense to utilize multiples of earnings. 

Nevertheless, here are the highlights:

• Sales are currently levered to Europe:  18% of 2012 revenues from the Americas; 70% Europe; 12% Asia
• $376 million in Revenue, 1H2013 (c. 48% yoy growth, due to Compton acquisition in 2H 2012)
• Segment revenue breakdown is frankly not helpful: $360.6 million lumped into commodities and resources, $6.2 million merchant banking, $9.4 million “other.”  No detail provided on individual commodities; margins of the various assets/ divisions; etc..
• $37MM EBITDA, 1H 2013
• Smith’s total salary, cash bonus & housing allowance comp. in 2012:   $579,000

Putting the Pieces together

Valuation Scenarios

($ millions)

There’s a fairly wide range here, and I think that’s appropriate, given the nature of the assets and subjectivity concerning the conglomerate/ opacity discount.   Given Smith’s willingness to pursue strategic transactions (spinoffs, etc.) to minimize the discount, it could be argued that it should be minimal over the medium / long term.                                                

Coming at it from another angle, one could argue that Smith entities have historically traded at tangible book value or above.  At today’s share price, the stock trades at 69% of tangible book.

Why the opportunity exists

1)      Zero analyst coverage

2)      Challenging environment for Alberta natural gas companies

3)      Concerns over Chinese steel demand ; soft 1H 2013 for Wabush iron mine

4)      Current market environment for commodity-focused names

5)      Entity size (c. $400M EV)

6)      Poor / irregular disclosure; not easy to diligence

7)      Conglomerate discount – perhaps unwarranted in a case where the CEO is the poster child for conceptualizing and realizing strategic alternatives

Catalyst