Description

Westaim is a bet on the jockey(s). I have a few numbers to back up my thesis, and I’ll have a stab at valuation, but it’s largely a qualitative argument. It’s also not the most liquid stock, but trades a few hundred thousand dollars a day, so probably only for small funds and Pas.

Note: The company reports in US$, but the stock price is C$

Westaim has a varied history, having been through a couple of major iterations in terms of form and focus. Today it is an investment company focusing on financial services with stakes in two interesting businesses run by capable but controversial managers. The company trades generally pretty thinly in Canada and there’s not a lot of coverage (Cormark, GMP and Beacon). In the end, the investment case boils down to something like “it looks like you’re betting alongside smart capital allocators at around book value”. I’ve had some good outcomes investing in that kind of situation, and while I could be wrong, I find this one interesting. I’ll keep the writeup relatively short and you can piece through the story for yourself.

Ancient History:

Most of this is not that relevant to the current story, given the company’s reinvention. Westaim was spun out of Viridian in 1996 with a rag-tag portfolio of early stage businesses including (per the company’s website) “coking-resistant coatings, electroluminescent flat panel displays, biomedical coatings, electronic ceramics and structural ceramics”.  Things went about as well as you’d expect, and ultimately the portfolio investments were liquidated, leaving a small cash pool and some tax assets.

The current story of Westaim begins in 2008, when Canadian value investment firm Goodwood acquired just under 20% of Westaim, and got two board seats for Peter Puccetti and Cameron(“Cam”) MacDonald, Goodwood’s Chairman and CEO respectively. MacDonald became Westaim’s CEO in April 2009 and still holds the position today.  Goodwood’s 2008 yearend letter (www.goodwoodfunds.com/wp-content/uploads/Goodwood-Annual-Report-2008.pdf ) is worth a look as it lays out their investment record (which is good, beating the S&P and TSX) and investment philosophy. It also explains the thinking behind the Westaim investment:

Our average cost per Westaim share is below $0.24 while the Company’s book value per

share is approximately $0.53 and is heavily composed of cash…..There are high-return transactions that can be pursued in a concentrated manner through Westaim given its capital base is permanent.

First Investment: Jevco

In January 2010, Westaim invested in a specialty insurance company called Jevco which was purchased from Kingsway Financial for about C$260 million. Jevco provided insurance for niches like motorbikes, ATVs and snowmobiles and higher risk drivers. Westaim bought it for around 95% of book. They financed this via a C$275million private placement and planned to grow the business. In 2012, Intact Financial made an unsolicited bid and Jevco was sold for C$530 million, with about C$520 million of the proceeds returned to shareholders as a dividend. www.westaim.com/wp-content/uploads/Jevco-Case-Study.pdf

Second Investment: HIIG

In 2014, the company again acquired an interest in an insurance company. Westaim formed a partnership with affiliates of Everest Re and Catlin Group, raised about C$150 million through a private placement and acquired the majority interest in Houston International Insurance Group (HIIG), the first of the two current holdings of Westaim.

HIIG is run by Stephen L. Way, a man with both positive and negative associations. Mr. Way was the founder and CEO of HCC Insurance (formerly listed on NYSE as HCC), a successful specialty insurance company. Way ran operations well for over 30 years from 1974 until he was booted out in 2006 because of an options backdating scandal. The options issue is one you can make your peace with or not, but operationally, things went well under his control – the company had consistently good underwriting results (average combined ratio of 90% and no years of adverse development 1994-2006, average ROE of 15.9%).

After leaving HCC, Way cobbled together HIIG through a series of investments and acquisitions.  If you go to http://www.westaim.com/investors/investor-presentations/ you can find the slide deck from the time of Westaim’s investment which lays out more detail. HIIG had trued up its reserves to deal with poor underwriting in the acquired businesses and placed several lines into runoff, but it provided the platform and licenses for Way to move forward and grow a specialty insurer, hopefully repeating his playbook from HCC.

HIIG’s book of business has continued to grow as the company has expanded, but given the relatively soft market conditions, it has made extensive use of cheap reinsurance to reduce net exposure. This reduces current profits but should leave the company well positioned to profit when the market hardens and pricing returns. Book value of equity at March 31st was US$328 million. At June 30th, the HIIG Partnership owned approximately 74.6% of the HIIG Shares and the Company owned approximately 58.5% of the HIIG Partnership for an approximate 43.7% indirect ownership interest in HIIG.

Third Investment: Arena Group

In 2015, Westaim funded Arena Group, consisting of Arena Investors, Arena Finance and Arena Origination. This deal brought Westaim to my attention. Once again, the firm was backing a fallen star, this time Dan Zwirn. Zwirn had previously run his own firm D.B. Zwirn & Co. The two things to know are first that the firm was shut down in 2008 due to accounting issues - the issue was well covered in the mainstream press, but the gist is that it was the CFO’s fault, Zwirn spent a lot of time and money on the investigation but was ultimately cleared of wrongdoing by the SEC. The second thing to know is that D.B. Zwirn produced outstanding returns: The D.B. Zwirn Special Opportunities Fund had gross returns of 21.8% in 2003, 21.6% in 2004, 18.9% in 2005, 24% in 2006, and 16% in 2007. (http://www.zerohedge.com/news/dizzying-rise-and-shattering-fall-dan-zwirn). The strategy was making loans to small and medium sized businesses with limited access to credit, generally secured by hard assets.

Westaim hopes that Arena can replicate that strategy (and hopefully the returns).  It has seeded Arena, but the real target is raising outside capital. Arena currently has committed AUM of about $625 million, including $125mm committed by Fairfax as part of a recent investment. The structuring of Arena is interesting, with Arena Finance and Origination capitalized by Westaim at $10 per membership unit, but with Zwirn and senior management given rights to buy in up to 20% (16.67% fully diluted) at prices escalating from $10.40 to $17.90. Arena managment and Westaim split the income from Arena Investors 51/49 currently, but this shifts more towards management as AUM and EBITDA increase. The slide deck from the November 2015 corporate update gives a good overview.

Further alignment is that Arena management are committed to investing in Westaim – 25% of the first $100mm of pre-tax distributions of Arena Investors, and 12.5% beyond that, up to a maximum of 19.9% of the outstanding shares. Zwirn invested C$2.5 million in the Westaim private placement.

Fairfax investment

In April of 2017, Westaim announced an investment agreement with Fairfax Financial. Fairfax was to make a private placement of up to C$100 million of 5% Preferred Securities. Westaim closed an initial subscription of C$50 million in June, and has the option of two more tranches of C$25 million by no later than December 31, 2017. The Preferred Securities can be redeemed by Westaim at any time after 5 years from closing, or after 3 years if its common shares are trading at a price of at least C$5.60 per share. Fairfax also gets 28.5 million Warrants at C$3.50 per share which vest proportionately to the drawdown of the Preferred. Importantly, Arena gets up to US$500MM of AUM as the preferred is drawn, the first $125MM of which was triggered by the initial draw.

Westaim have invested the proceeds from the Preferreds with Arena, which should provide a positive carry while they look at other investments.

While 28.5 million warrants is meaningful potential dilution on a sharecount of 143.2 million shares, I think it’s a good deal. It gives both Westaim and Arena the implicit seal of approval of the well-regarded management of Fairfax which will hopefully accelerate the process of gathering third party assets at Arena. It also accelerates Arena on the path to $1B AUM, and for some clients with both minimum investment sizes and maximum concentration allowance, that should be a positive.

Insider ownership.

Delaney and MacDonald have real skin in the game, and have spent meaningful cash out of their own pocket to buy shares, as has Zwirn more recently. In Zwirn’s case, it could perhaps be argued that it is part of the deal but it’s a meaningful amount and will put a bid under the stock. I doubt he’d have agreed to it if he thought the company was junk.

Valuation:

There’s a few ways to look at Westaim and what follows is an exercise in hand waving. Book value per share was C$2.91 at the end of Q2, so you’re buying in around book value to invest alongside some apparently smart folk who will hopefully compound your money at good rates going forward.

HIIG is carried on the books at US$148.8mm.Your bull case is that the insurance market hardens again, HIIG performs like HCC did and is valued like a good specialty insurer, maybe at 1.5x book value (which I would expect to grow rapidly in a hard market) US$328 x 1.5 x 43.7% = US$215mm. So for now say US$149 - US$215mm.

Arena is trickier to value. The fair values of the investments in Arena Finance and Arena Origination were US$147.5 million and US$32.7 million at the end of Q2. For the stake in Arena Investors, the value will depend on growth in AUM (and obviously performance). Here’s a SWAG at valuation: Assume that Arena gets to $1B AUM, producing 12% returns and 2 & 20% fees, using run-rate Q2 expenses and EBITDA should be around US$20mm. Put a 9 multiple on it, 51% goes to Westaim gives about $90mm of value.  Add up all the parts and we get maybe US$270 all in for Arena.

Central Costs – these look to be running around US$9mm/year including SBC. Put a 9

 multiple on that, and it’s -$80.

HIIG $148-$215

Arena $270

Corporate -$80

At an exchange rate of 1.23 C$/US$, that gives about C$420 - C$500 of value.

At June 30^th, there were 143.2mm shares outstanding, plus 6.6mm options at C$3.25, 3mm RSUs, and 28.5mm warrants at C$3.5. Assuming all that gets exercised, you have 181.3 mm shares and another C$120mm of cash

You can add make your mind up about different scenarios, but playing around with the above I get $3-$3.40, for what that’s worth. Simpler to say that trading below book value of just under $3 today I think Westaim is at least a fair price for good businesses with very interesting growth optionality, run by managers with decent track records. If HIIG gets its hard market and Arena continues to grow AUM, the company should be worth north of $4/share. I think there’s a good chance that both segments compound value at a decent rate from current levels, and we have the free option that Westaim’s management finds new opportunities to invest in going forward.

Risks:

·         Dead money risk. We are waiting for growth in both Arena and HIIG. HIIG is a meaningful chunk of the value but is currently under-earning and the business is going to have to wait for a cycle turn.

·         HIIG appears to have properly reserved after taking some charges related to legacy business, but there’s always the chance of more

·         Arena’s investments could seriously underperform in a downturn given the focus on smaller less liquid loans.

·         Key men risk – Way and Zwirn appear to be good operators, but they stubbed their toes before.

·         Possible further RSU/ Option dilution – insider ownership should mitigate this risk to some degree.

·         Potential for a bad deal – HIIG and Arena look interesting but there is limited track record. Jevco is the only realization so far, and that investment came during a different part of the cycle.

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author or affiliated funds  presently has a long position in securities of this issuer and may trade in and out of these positions without notice. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. Please do your own work.

Catalyst

Hardening of specialty insurance market

Growth of AUM at Arena

Potential for new investment