Description

Trading Emissions Plc

Ticker: TRE LN
Stock price: 13p
Shares outstanding: 249,800,000
Market cap: £32.47m

Trading Emissions Plc (TRE) is a liquidating trust with a high probability of delivering very attractive returns over the next year or so.

Although there isn’t too much transparency into the company’s remaining assets, given the massive sell-off in the market (exaggerated due to forced selling as I’ll explain below), investors are currently buying the company’s remaining private equity portfolio at a ~70% discount to the most recent, post-markdown values.

Given that the company is likely to distribute 6p per share, or roughly 46% of its market cap, within three months, even if we haircut the remaining private equity (PE) portfolio by 30% and assume corporate running costs, wind-up costs (detailed below) I estimate an IRR of around 40% if liquidation happens by July of next year. If it takes an additional year the IRR drops to 16% although it’s likely to be higher due an additional interim cash distribution.

On the downside, the company’s PE portfolio would have to take a hit of 57% from its current valuation in order for an investor to break even given all the costs. After the recent markdown in the PE portfolio and due to the nature of the remaining investments – and the price you’re paying for them – I believe the odds are skewed heavily in the investor’s favor.

Background

TRE’s board was taken over by activist investors in 2011, and today consists of the Chairman Martin Adams, who is very experienced in these types of liquidations; Norman Crighton, who is similarly experienced and comes from the CEF analyst buy/sell side; and Chris Agar from Laxey Partners, a CEF activist (you can read about their credentials starting on page 11, here: http://www.tradingemissionsplc.com/Notice_of_AGM_2012.pdf).

I’m not going to dive into the mess that was TRE’s PE and carbon portfolio, as that’s in the past and largely irrelevant for the investment thesis going forward.

Suffice it to say, however, that this complexity has resulted in the shares trading at a substantial discount to NAV. As a result, TRE has been a fantastic investment if you were able to figure out the risks and the opportunity, because the directors have been able to make substantial cash distributions which have lowered the cost basis to the investor over the past 15 months, resulting in a very attractive IRR, even after the share price decline of ~28% this year.

Forced Selling

On March 24, TRE released its half year report, in which it revealed that the PE portfolio was written down. The stock had closed Friday at 16p, and the new NAV post write-down came in at 22.38p, compared with NAV of 30.08p for the last yearly report (Jun 30, 2013).

A journalist in the UK had been recommending this stock to his readers over the past two years. Given the small size of the company, each buy recommendation would send the stock up as his readers would pile in. On Monday, the journalist got discouraged with the PE portfolio write-down and recommended that his readers sell, sending the shares down ~22% on almost 3x the normal trading volume.

There were numerous problems with the journalist’s assumptions. First, he assumes that the PE portfolio write-downs will continue. Given the nature of the remaining assets in the PE portfolio (detailed below), I believe this is unlikely, however, we can haircut the PE portfolio by an additional 30% and still arrive at an attractive return.

Secondly, he assumes wind-up costs of £10m or 4p per share (18% of NAV). This is ludicrous. The company has guided to wind-up costs a tenth of that, at £1m or 0.4p per share (2% of NAV).

However, since a publicly traded shell is valuable (given set-up, registration and IPO costs – I’ve heard a public shell on the LSE is worth £2m on that basis alone), it’s more likely that once all assets are liquidated and returned in cash to shareholders, that TRE is renamed and used for another purpose.

As a result of the mass uneconomic selling following the publishing of this article, the new price of the shares makes them attractive again.

The Opportunity

TRE has three broad components: cash, a private equity (PE) portfolio, and a carbon credit liability.

Here are the reported values:

These values must be adjusted for the receipt of cash from one of the portfolio companies, after the reporting period, as noted in the financials just released. The amount is £5.8m, and I assume it grows the cash pile and shrinks the PE portfolio’s value by the same amount.

Furthermore, the consolidated financials of TRE are useless from an analytical standpoint and the directors note that the fair value of the PE portfolio is 13% above the consolidated amount. This bumps the PE portfolio by £5.5m. The net result:

Net of net cash of 7.92p, you’re paying 5.08p for a private equity portfolio valued at 16.65p. That’s a 70% discount.

TRE has indicated that it expects to make a further distribution before the financial year-end, that is, before June 30. That is three months from now. Given the cash pile, I expect the distribution to be around 6p per share.

The company has guided for yearly running costs of £2.0m or 0.8p, substantially lower than historical costs due to the renegotiation of the management fee with TRE’s original manager, EEA Fund Management.

I’m modeling £3.3m of running costs for conservatism, an additional £1.0m of wind-up costs (if this doesn’t get wound up, then this should be zero), and assume we get all cash back by the end of the financial year (June 30) in 2015.

There are a few success fees but these are not terribly material to the thesis or the IRR calculations. Here’s how it pencils out:

3/26/2014: investment at 13p
6/30/2014: return of capital of 6p
6/30/2015: return of capital of 16.45p

Total “realizable NAV” after expenses, approx 22.45p.

IRR: 80%

Assuming a further 30% write-down on the PE portfolio gets you an IRR of 40%.

Extending the final liquidation by a full year results in IRRs of 37% and 16% respectively, although I expect interim cash distributions to juice those numbers.

The way you break-even on this is if the PE portfolio gets written down by 57%. I find that unlikely.

The PE Portfolio

There isn’t a lot of detail on TRE’s remaining private equity portfolio, but the bulk of the value seems to be in Surya Plc, Element Markets and EWG Slupsk. You can read more about these in the annual report: http://www.londonstockexchange.com/exchange/news/market-news/market-news-detail.html?announcementId=11760447

Surya Plc

Surya Plc, 100% owned by TRE, is a photovoltaic installation in Italy with 24.6 MW of capacity. It is well financed (and has recently been refinanced, resulting in a substantial cash distribution to TRE), and has a signed power purchase agreement.

The issue with this investment is that the solar panels have experienced faster degradation than expected. Fortunately, the contractor for the project is a very well known and reputable European vendor, and while it may take a few more months to fully assess and rectify the problems, the panels will be replaced.

TRE has been in discussion with a serious buyer for over a year. They’ve completed their due diligence but want reps and warranties for another two years. So most likely what will happen is that they will buy insurance and TRE will pay the premium (no estimate on what this could cost, but I assume it’s not material to the thesis).

Despite the issues here, this asset seems to be pretty straightforward and I don’t expect severe write-downs at this point. TRE has invested a net £25.7m in Surya or 10.3p per share.

Element Markets

This company, 51.2% owned by TRE, is a “leading producer and marketer of renewable natural gas and environmental commodities in the U.S.” You can view their website here: http://www.elementmarkets.com/index.php and learn more from the annual report. TRE has invested a net £31m in Element Markets or 12.4p per share.

The latest report indicates that Element Markets generated £37.6m of revenues for 2013, 2.6% over budget. Back in 2012, the company indicated they expected to get up to 30m USD for its Element Markets stake, which would be about 7.3p per share.

EWG Slupsk

This asset, 60% owned by TRE, is a project for a wind farm in the north coast of Poland consisting of 98 wind turbines with 245 MW of capacity. TRE has invested a net £11m in EWG Slupsk or 4.4p per share.

All land leases and permits have been secured and a grid connection agreement with the Polish transmission grid operator was signed in 2010.

There have been recent regulatory issues noted in the annual report, and the half year report has language indicating that the new Polish law on renewable energy will make it easier to sell this asset. TRE has been in exclusive discussions with a potential buyer.

***

These are the main assets in the PE portfolio.  It’s impossible to value their equity to TRE as we don’t have much detail, but presumably the directors have valued these very close to the final realizable transaction values.

While there are other PE assets owned by TRE, they are valued at either zero or very close to zero and I don’t expect any meaningful impact from them either way.

Carbon liability

TRE was in the business of setting up projects around the world to generate carbon credits. If you’re not familiar with this, the basic idea is that it’s cheaper to eliminate one ton of carbon emissions in Brazil than it is in the UK, for example.

So you’d set up a project in Brazil that would generate energy while producing fewer emissions than a benchmark. The project would get certified by an international body, and would earn carbon “credits.” These credits could be sold to companies in developed nations wishing to offset their carbon footprint. In certain countries, caps were put in place on carbon emissions, so companies indeed needed to buy carbon credits to stay within regulations.

Unfortunately, the amount of carbon credits produced flooded the market; regulatory uncertainty over the future of the “cap and trade” mechanism further pressured the price of carbon credits. TRE had contracts in place to buy carbon credits from its projects at a certain price per ton, but the spot market had crashed way below that price, leaving TRE with a huge carbon liability.

TRE has since renegotiated many of the carbon delivery deals it has, the carbon liability has shrunk dramatically. I expect the carbon liability to dissipate over the next year and it is unclear how much of the current booked liability will actually materialize, but I assume all of it will.

Risks

The biggest risk is obviously the PE portfolio, although given the nature of the remaining assets, I am optimistic that we are close to the endgame in terms of finding buyers at close to current estimated values.

TRE doesn’t break out its PE portfolio so it’s impossible to attribute values to each asset, but I expect the majority of the value to be concentrated in the three assets detailed above.

Catalysts

TRE should distribute a substantial amount of cash, perhaps 6p per share, before the end of the financial year (June 30). Any additional resolution on the sale of its PE assets could result in additional distributions sooner than expected.

Catalyst