Equity Research Piece: Sterling Construction Co. (STRL)

I came across Sterling Construction Co. (STRL) after running a screen on Capital IQ for companies with: low debt levels, market caps between $100M and $500M and trailing EV/EBITDA multiples below 7x. I happen to believe that there is a lot more inefficiency in the small cap space and thus I often dig in that arena. What I quickly saw was that companies reliant on government infrastructure spending were trading at very low EV/EBITDA multiples. In fact, during my research I also came across Orion Marine Group (ORN), a company that operates in similar markets to STRL. At first I was intrigued by the valuation of ORN, but after more digging, STRL became the more compelling research candidate.

Unfortunately, I discovered the company a few weeks too late. On March 14th, 2011, the stock closed at $12.48, a price that implied a trailing free cash flow yield over 18%. Since then the stock has jumped to a price above $16 and no longer offers a sufficient margin of safety for my taste. However, I do think the stock bears watching because of the uncertainty surrounding state infrastructure spending. It is possible that the pessimism regarding states' ability to fund capital expenditures will drive the stock price down to a level that more than compensates for the inherent risks. Plus, I believe that STRL is a takeout candidate because the larger players such as Fluor and KBR may only be able to achieve growth through acquisitions over the next few years.

I should mention that this is my own personal research and the analysis and opinions presented should not be attributed to West Coast Asset Management. I hope you enjoy the piece as a I think it is representative of the type of research I like to do. For those of you who do not have time time read all 12 pages, I have included an executive summary in the first two pages of the write up. Please feel free to make comments or suggestions. I am always looking for feedback on my research, both positive and constructive.

As usual, I have put the write up in Scribd format to preserve the formatting of the charts. However, if you have trouble downloading the piece, feel free to email me and I will happily send you a copy.

Sterling Construction Co. Write Up

The Investment Case for PMACA

Finally, I get to post some research. The following piece is an updated and expanded version of the research that I have been pitching to anyone and everyone who will listen. The last time I liked a P&C insurance company this much the company was IPC Holdings and Buffett/Berkshire made a bid for it before it got taken out by another company. Very simply, this microcap stock is under-followed and unloved and the market has yet to fully notice that the company has removed the overhang that has clouded the stock since about 2005.

I know this stock is not for everyone, but I think the valuation is compelling and the risk-reward is very attractive at the current price. As usual, I have kept the document in Scribd format in order to preserve the formatting of the charts. If anyone would like a PDF of the research, please feel free to email me. Also, I welcome any comments or questions.

PMA Capital Corporation (PMACA) Research

Return Fom the Abyss

Readers,

I must apologize for my absence. This past quarter at school was uniquely intense and I was forced to give up many things that I enjoy. I am very hopeful that next quarter I will be able to keep up with the blog and will do my best to try to balance the many obligations I have in my life.

I return with updated research on Synovus (SNV). The stock has had an amazing run from $1.92 in December when I first wrote about it to around $3.56 today. I think the long-term earnings story is still intact but with a second wave of bank losses on the horizon, an investor who buys in now might suffer some initial losses before eventually realizing a substantial gain later.

As always, I appreciate your comments and questions. Here is the piece in Scribd format to preserve the formatting of charts:

Updated Research on Synovus (SNV)

The Bull and Bear Case for Synovus Financial (SNV)

In response to a piece penned by Tom Brown of bankstocks.com about Synovus Financial, I carefully go through his bullish arguments and point out areas in which we do not share the same outlook. Tom Brown is an experienced analyst who has far more experience than I have. Accordingly, this is absolutely not an attempt to undermine his work. However, after digging into the credit trends I came to different conclusions about the near term prospects for SNV. Despite this fact, I actually do agree with Brown that that over the next few years there is the potential for the shares to appreciate meaningfully. But, in trying to assess the potential risks, the questions I try to answer are as follows: (1) Will SNV have enough capital to make it through the cycle without further diluting shareholders and (2) What is the probability that SNV does not survive this credit cycle?

(Picture courtesy of brandsoftheworld.com)

Research Report on Synovus Financial (SNV)

A Bank You Might Actually Want to Own

The following is a brief write up for Toronto-Dominion Bank (NYSE: TD). As usual, I have translated the piece into Scribd to preserve the formatting of the charts. If you would like a Word copy feel free to email me and I will send you one.

While the company's foray into the US market through the purchases of BankNorth and Commerce Bancorp has not gone quite as planned, overall TD is a solid bank with a conservative approach. The stock is currently trading at a discount to Royal Bank of Canada, Bank of Nova Scotia and Bank of Montreal on a price to book basis. Even given the emerging troubles in the US portion of the loan portfolio, the discount that TD trades at compared to its competitors does not seem justified. Specifically, over the last 12 months TD has had the highest net interest margin, a figure that is a good barometer of the strength of a banking franchise. Additionally, TD has set aside the largest percentage of total loans for credit losses even though its nonperforming loan to total loan ratio has been the lowest of the group. All in all the shares look a little pricey at the current level but investors should look to accumulate shares in the $50-$55 range based on my estimate of intrinsic value around $66 a share. Buying in this price range would allow for a 20-25% margin of safety to protect against any overestimate or impairment of intrinsic value.

(Picture courtesy of Canada.com)

Quick Idea for Toronto-Dominion Bank (TD)

The Investment Case & Valuation for Altisource (ASPS)

The following is my in-depth analysis of recently spun off Altisource (ASPS). The company looks to have some interesting growth opportunities and room to improve margins. However, the current price appears to reflect those positives. Therefore, my advice is to continue to monitor the stock and look to buy around $10 per share.

I have kept it in Scribd format to try to preserve the formatting of the charts. If anyone would like a Word copy feel free to email me.

Also, I am constantly trying to improve my research skills so I would genuinely appreciate any feedback from readers.

The Investment Case and Valuation for Altisource (ASPS)

Analysis of Australian Bank Fundamentals

I know you all have been breathlessly awaiting my follow up report on the Australian banks. Fortunately, the wait is over. In this section I attempt to add even more evidence to support my claim that the housing markets in AU and NZ are overvalued and are on the precipice of a fall. I also had the unique opportunity to interview a very insightful AU hedge fund manager who gave me an incredible amount of information. The piece also includes an analysis of why I think ANZ and CBA are the best in class and why I see BOQ as the weakest of the group. I then conclude with some strategies for investing based on my thesis regarding the housing market. For those of you who are not particularly interested in the stocks themselves, I still think the commentary from the fund manager and the comparison regarding affordability of housing markets in the English speaking world are very interesting. Just like last time, I have kept the article in Scribd format to preserve the formatting of the charts and quotations.

(Picture courtesy of www.abc.net.au)

Analysis of Australian Bank Fundamentals

Is it Time to Start Worrying about the Australian Banks?

This is the first piece in a two part series on the Australian and New Zealand banks. The initial post focuses on the macroeconomic issues facing these countries while the second one will focus on the banks themselves. We all know what has happened to the banking system in the US as a result of falling house prices. Could the AU-NZ banks be in for the same sort of fall? Some data indicates that answer could be yes. Not to spoil the surprise but it looks at though some of the major factors that have plagued the US housing market are to some extent present in this region as well. The most important of those is, of course, the dreaded consumer leverage.

I haven't seen a whole lot of press in the US on the housing market in the AU-NZ footprint and I think some of the similarities are eye opening and could suggest that the market may be on the same precipice the US market was about to fall over in late 2006.

I have kept the document in the Scribd format to preserve the formatting of the charts and quotations. Next week sometime I will post a detailed review of the individual banks in an attempt to figure out if there are any long or short candidates in the group. In the meantime I would love to hear you comments. Enjoy!

(Picture courtesy of www.iusb.edu/~sbglobal/passport.html)

Australia-New Zealand Banks

Assessing the Rise from the Grave of the BDCs

I have some particularly interesting investments for you to consider for your portfolio. Nowhere else are you going to find such an eclectic selection of both debt and equity securities. Would you be interested in senior secured debt of safety footwear manufacturer Shoes for Crews? Or how about some common shares of specialty trailer manufacturer Universal Trailer Corp. (see picture above)? No wait, even better. I have some senior subordinated debt from private school operator Instituto de Banca y Comercio, Inc. that I know you are going to love. How can you invest in these fabulous companies? Well, according to a recent 10-Q filing, if you buy shares of publicly traded Ares Capital (ARCC) you can become a part owner of these securities as well as a plethora of equally obscure ones.

Now, I don’t mean to disparage these companies. For all I know they are wonderful businesses run by masterful capital allocators who put the interests of their shareholders first and foremost. The problem is that there is just no way for me to assess the quality of these companies or the value of the securities owned by Business Development Companies (BDCs) like Ares Capital. This is the crux of the problem for the BDCs: very little transparency. When people talk about balance sheets that are equivalent to black boxes, they are often referring to those of the (former) investment banks such as Goldman Sachs (GS) that contain millions (if not billions) of dollars of hard to value Level 2 and 3 assets. However, as I began to peruse the balance sheets of the publicly traded BDCs it quickly became abundantly clear that the black box description was particularly fitting for these companies as well.

According to Wikipedia:

A Business Development Company or BDC is a form of publicly traded private equity vehicle in the United States. Historically, in the United States, there had been a group of publicly traded private equity firms that were registered as business development companies (BDCs) under the Investment Company Act of 1940.Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return, REITs are required to distribute 90% of their income, which may be taxable to its investors.

In more benign times in the credit markets these vehicles were relatively attractive investments. They paid substantial dividends, gave investors enamored with the private equity model exposure to small and mid-sized companies, and often weren’t quite as levered as some other investment vehicles. Unfortunately, the recent dislocation in the credit markets as well as the growing concern about the value of private equity debt that was financed during the boom has absolutely decimated the BDC space. Specifically, the average decline from the 52 week high of the 10 BDCs I reviewed is 59.4%. This is after an astounding rise in the past few months that has brought these stocks, on average, up 220.7% above their 52 week lows. Accordingly, with such a large move off of the bottom I thought it would be interesting to check in on the BDC space to see if the share appreciation was warranted or if the BDCs’ business model had been made unsustainable by the events of the past couple of years.

This first chart illustrates the magnitude of the volatility in share prices for these BDCs over the last year. During the worst period of the bear market in March of this year many of these companies traded as if they were going out of business, with a number of them trading under $1. While it is seductive to look at a possible return to those 52 week highs and see potential 10 baggers, it is important to remember that those prices were reflections of a global economy and credit markets that were very different than they are today. Therefore, the most pressing question for interested investors is what is the new baseline for these companies going to look like? Assuming that we do not go back to the boom years of cheap credit and completely mispriced risk any time soon, how do you value the BDCs in a “new normal” environment?

6/18/2009
Ticker	Stock Price	52 Week High	% <>	52 Week Low	% > 52 Week Low
AINV	$6.44	$20.29	68.26%	$1.99	223.62%
ACAS	$3.27	$32.41	89.91%	$0.58	463.79%
ALD	$3.10	$19.99	84.49%	$0.58	434.48%
ARCC	$8.05	$13.00	38.08%	$3.12	158.01%
GAIN	$4.10	$9.04	54.65%	$2.26	81.42%
GLAD	$7.33	$19.14	61.70%	$4.72	55.30%
KCAP	$5.79	$13.41	56.82%	$1.24	366.94%
PCAP	$1.58	$10.43	84.85%	$0.88	79.55%
PNNT	$7.45	$8.64	13.77%	$2.09	256.46%
TICC	$4.15	$7.10	41.55%	$2.21	87.78%
Averages			59.41%		220.73%

This next chart compares the current valuation of these companies to their averages over the last few years. It should be noted that some historical valuation data is a bit limited because many of these companies became publicly traded only in the last 3 to 5 years (not surprising given the boom in private equity from 2005 to early 2008). In general these stocks trade on multiples to NAV. In the case of these BDCs, NAV is equivalent to book value per shares and tangible book value per share as none of these companies have any goodwill or intangible assets.

			2005-2008		Annualized
Ticker	NAV/Share	P/NAV	Average P/NAV	Recent Dividend	Dividend Yield
AINV	$9.82	0.66x	1.14x	$0.26	16.15%
ACAS	$12.32	0.27x	1.31x	$0.00	0.00%
ALD	$7.67	0.40x	1.42x	$0.00	0.00%
ARCC	$11.20	0.72x	1.05x	$0.35	17.39%
GAIN	$9.73	0.42x	0.88x	$0.12	11.71%
GLAD	$12.10	0.61x	1.46x	$0.21	11.46%
KCAP	$11.53	0.50x	0.88x	$0.24	16.58%
PCAP	$8.13	0.19x	1.45x	$0.00	0.00%
PNNT	$12.00	0.62x	0.70x	$0.24	12.89%
TICC	$7.46	0.56x	0.96x	$0.15	14.46%
Group Averages		0.49x	1.12x		10.06%

* Average P/NAV for AINV was calculated using fiscal year end price divided by fiscal year end book value

* Average P/NAV only includes 3 years of data for GAIN, 2 years for KCAP and 2 years for PNNT

*Sources: Cap IQ, Yahoo Finance, and my calculations

When you compare the average multiples prior to 2009 to the current multiples the wholesale contraction in multiples that the market is willing to pay for these companies becomes readily apparent. The concern that I have and that I believe is shared by many investors is that NAV is a moving target and it impossible to verify or reliably calculate. With so many illiquid private investments on the balance sheet, the BDCs have a tremendous amount of discretion in terms of valuing these securities. In his book “Fooling Some of the People All of the Time” about the alleged fraud at Allied Capital (ALD), hedge fund manager David Einhorn goes into great detail regarding the potential for valuation shenanigans and the problems that even very astute investors and regulators have in terms of spotting misevaluations. Accordingly, an investment in one of these companies is tantamount to a blind leap of faith that the management teams are trustworthy, conservative in their valuations and can manage a portfolio of obscure securities under very severe economic circumstances.

To highlight the problem in assessing the merit of valuation, I think it makes sense to go through an example. One of Einhorn’s major criticisms of ALD is that the company took way too long to write down the value of obviously distressed securities. In the book he discusses a number of occasions in which ALD wrote down the equity investment a company to $0 but still carried the debt at 100 cents on the dollar. While scenarios do arise all the time in which equity holders are wiped out but the assets on the balance sheet are sufficient to cover the senior debt, liquidations are often very uncertain and conservative managers should feel compelled to reflect that in the form of write down. What investors have to be leery of is a company that waits until a piece of debt either stops paying interest or becomes impaired before writing down the value of the asset even though there is ample evidence that the underlying business is struggling.

I found a great example of this difficulty in assessing the value of impaired securities in the recent 10-Q’s of ALD and ARCC. Both companies own the subordinated debt and some common shares of clothing company Wear Me Apparel LLC. Each company indicates in its filings that the debt security is non-income producing, a circumstance that indicates a write down is necessary.

Wear Me Apparel LLC
ALD
Security	Maturity	Cost	Current Value	% Write down
Senior Subordinated Debt	2013/14	$138,559	$46,932	66.13%
Common Shares	N/A	$39,635	$0	100.00%
ARCC
Security	Maturity	Cost	Current Value	% Write down
Senior Subordinated Debt	2013	$24,110	$12,055	50.00%
Common Shares	N/A	$10,000	$0	100.00%

The interesting to note about this chart is that even though both companies have written down their common shares to $0, ALD has chosen to write down the debt by 66% while ARCC has only written it down by 50%. Which company’s valuation is more accurate? The answer to that is impossible to know but even small differences can be meaningful when applied to a portfolio with hundreds of companies. This discrepancy in valuation is one reason why the market is pricing the BDCs well below NAV and illustrates why investors who are interested in buying these stocks should price in a significant margin of safety.

Accordingly, the logical question to ask is whether the current depressed valuations reflect the stress on the portfolios from the recession, the inherent difficulty of valuing the underlying securities and the lack of funding available for balance sheet growth as a result of the shut down in credit markets for private equity? Unfortunately, I don’t have a good answer to that question. But, as a result of all of the uncertainty that surrounds the companies’ balance sheets and funding model, it is just too risky a space for me to allocate my capital. There is no question that the dividend yields are attractive and investors who can identify the companies most likely to survive the cycle are essentially getting paid to wait for the economy to turn around and the credit markets to become less constrained. However, as the economy worsens a lot of the BDCs will be forced to write down their portfolios even further and potentially breach debt covenants that require minimum leverage ratios.

I personally don’t want to wake up one morning an see an 8-K from a company in my portfolio that indicates that as a result of a breach of a covenant on $2.3B in borrowing agreements the company’s auditor now doubts that the company in question can remain a going concern. This is what happened to ACAS. Despite that the stock has run up from a 52 week low of $.58 all the way to $3.27, an amazing 463% appreciation. This is the type of thing that makes me skeptical of the current valuations, no matter how depressed they are. Accordingly, I am content waiting on the sidelines to see if the best in class of these companies (likely AINV) trade down to prices that provide an irresistible margin of safety or optionality. As a result I may never have the pleasure of being a part owner of the stock appreciation rights of ALD’s portfolio company Oahu Waste Services, but at least I won’t be up at night worrying about what the effect of the recession in Hawaii is going to be on my portfolio.

(Picture courtesy of http://www.universaltrailer.com/)