Above Average Odds Investing

The investment analysis below is our fifteenth in our ongoing series of guest posts, and is brought to you by friend of the blog Lane Sigurd. Lane‘s background is in oil & gas, and he author’s one of my favorite new blogs (the outstanding) Reminiscences of a Stock Blogger. I mean with a tag line like “moneyball without the ball” you know its good.

Lane and I have gone back and forth for almost a year now swapping ideas and digging for value, and it wasn’t long before I realized that not only did I love the way the guy thinks, but that we shared a similar addiction to the pursuit of misunderstood or under-appreciated value in the small and micro cap space. So a friendship was born and this is yet another example of a guest post that’s been a long time coming.

So with that said, let me introduce you to Lane’s latest on PHH, a write-up that we’ve been planning to co-release for a couple of months now and should help outline why we feel it’s pretty hard to lose here given the rock solid downside protection and the likely spin (or divestiture) of its fleet business at some point within the near to medium term. While not official, a close reading of the tea leaves (recent changes at the executive level, undeniable strategic and financial logic, etc. etc.) suggests we’ll see one sooner rather than later, and in the process provide shareholders with a high probability catalyst that would unlock substantial embedded value by forcing the market to assign a value to the companies market leading fleet operations. I don’t know about all of my readers preferences, but while I like cheap, I like cheap a whole lot more when its coupled with a high probability hard catalyst, and that’s what I think we have here.

If we’re right about all of this then (really, even if we aren’t), the asymmetry of an investment at or around today’s price is hard to ignore, as I think a spin should cause the stock to roughly double upon consummation, and any normalization in MSR multiples and housing generally could cause it to promptly double again as (1) servicing costs normalize (2) interest rates rise, and as a result (3) TBV is written up to reflect the true value of it’s long duration, high quality servicing annuity (fwiw, I think one could argue that the servicing cash flows are worth much more than say the normalized 4x-6x historical multiple given where we are in the cycle but that’s a discussion for another day and ultimately irrelevant to the thesis at this valuation).

Again though, with interest rates at a 30 year low (and more importantly, at the zero bound) they have nowhere else to go but up, which we would remind readers that this will start to choke off (1) any material refinancing activity (which shouldn’t consist of much looking forward as is given its reasonable to assume that most everyone that hasn’t refinance by this point probably can’t/won’t and (2) the slow drip of MSR related write downs that have been a constant headwind to this business for a very long time. The takeaway then is that PHH has already come through the worst of a multi-decade storm and given the valuation, the market has yet to take notice.

Add it all up, and it seems like this indeed has all the trappings of a classic Greenblatt style home run.  Enjoy!!!

Thesis:

I swear its the name of a book, not the punchline of an infomercial

You Can Be a Stock Market Genius was written by Joel Greenblatt in 1999.  It is an oft recommended book by value investors.  The recommendations, however, generally come with the following caveat, or something similar in effect:  “Now I know the title is awful but…”

If you can get past the cheesy title and into the meat, the book provides an investor with a wealth of knowledge, focusing on areas of the stock market that are overlooked by most investors, and explaining how you can find value there.

One opportunity that is discussed at length in the book is the spin-off. A spin-off typically occurs either when the company feels that the sum of the parts is greater than the whole, or when a bad business is overwhelming the perception of a good business.  Usually a spin-off involves two or more businesses that are mostly mutually exclusive from one another.

The basic premise of the spin-off is that the underlying businesses will be realized for a higher value separately then they are being realized for together.  In his book, Greenblatt focuses on the inefficiencies with the spin-off process.  In many cases investors of the original security will be more interested in one of the resulting securities than the other.  In some cases the spin-off will result in one entity that is far smaller than the other, and institutions with size limitations on what they can hold will be forced to sell.  These reasons lead to a lot of selling pressure over a short amount of time, which can depress one of the spin-off companies and lead to a good value situation.

I want to focus here on the basic premise of a spin-off; that the businesses that underly the parent company are undervalued as a whole, and that often there is money to be made simply from the recognition of value brought about by their separation.  The intent of the spin-off is to create value, and often times it works.  There are plenty of examples of company’s whose stock popped on the announcement of a spin-off or divestiture.  With investors being more able to focus on the simpler business structures of the resulting spin-off companies, the value is more readily perceived.

The Spin-off Potential of PHH Corp

I believe that PHH Corp is an ideal candidate for a spin-off or a divestiture that would create significant value for shareholders.  Moreover, even if a spin-off never happens, the value is there to be realized and the market appears to be in the process of reevaluating its worth.

PHH is involved in two businesses that, from what I can tell, have very little efficiencies with one another apart from the fact that both involve money.

1. Mortgage Origination and Servicing
2. Fleet Management Services

When I became interested in PHH Corp a few months ago it was because of the Mortgage Origination and Servicing segment.  PHH is one of the few large originators out there that trades publically.  I learned about the company while reading a 13G filing from Hayman Capital, the investment management firm run by Kyle Bass.  Bass took a 7.9% stake in the company.

My initial investment analysis focused on the servicing and origination segment of the business.  I was pretty sure I could see the value that Bass saw, and I will get to that in a minute.  I bought the stock soon after and watched it do well for a couple of weeks.

Well at some point my procrastination was overridden by my curiousity and I thought I better take a look at this Fleet Management business.  To be honest, I didn’t even know what Fleet Management was.  What I was shocked to learn was not only that Fleet Management is a solid, growing business, but that an argument could be made that its value alone could be worth a large percentage of the PHH market capitalization.  I can imagine a scenario where the Fleet Management business is spun off or divested from the mortgage business, with the result being a significant realization of shareholder value.

What is Fleet Management?

The best definition I could find as to what the business of fleet management is all about came from wikipedia:

Fleet management is the management of a company’s vehicle fleet. Fleet management includes commercial motor vehicles such as cars, vans and trucks. Fleet (vehicle) management can include a range of functions, such as vehicle financing, vehicle maintenance, vehicle telematics (tracking and diagnostics), driver management, speed management, fuel management and health and safety management. Fleet Management is a function which allows companies which rely on transportation in their business to remove or minimize the risks associated with vehicle investment, improving efficiency, productivity and reducing their overall transportation and staff costs, providing 100% compliance with government legislation (duty of care) and many more. These functions can be dealt with by either an in-house fleet-management department or an outsourced fleet-management provider.

Its a fairly simple business, and one that has proven to be consistently profitable even through one of the worst recessions ever.

The hidden consistency of Fleet

I went back a few years and looked at the earnings numbers on the PHH Fleet business:

Average earnings from Fleet over the past 6 years have been $0.83 per share of PHH.   Even in the depths of the 2008-2009 recession Fleet delivered respectable earnings.

The Fleet business continued its operational performance in the first quarter of this year and looks ready to break above a $1 per share in earnings for the first time since 2007.

Think about that for a second.  Here you have a business that has shown the ability to earn money consistently, even through what was probably the worst recession of our generation.  It could quick likely earn $1 per share of earnings this year.  Earnings have grown in the high teens for the past 3 years.

What would you value such a business at?  12x earnings? 15x earnings?  Maybe more?

If you use either of those multiples on the average and peak earnings numbers, it becomes clear that the Fleet business is worth something not too far away from the current stock price.  Or in other words, when you are buying PHH you are buying the mortgage business for very little.

Moreover, as one would expect, the Fleet Management business is going to improve along with the economy.  As per last year’s 10-K:

The fleet management industry continues to be impacted by the relative strength of the U.S. economy. As the U.S. economy improves, we expect to see continued improvement in the industry. We believe that improvement in the economic conditions will be reflected in continued growth in our service unit counts.

If the US economy is indeed improving, the Fleet business could turn out to be a cash generating machine.

This all leads to the speculation of whether there could be a spin-off or sale of Fleet from the rest of the company at some point.  A sale of Fleet would provide the cash needed by the servicing business to grow and allow PHH to continue their correspondent lending business at higher levels.  A spin-off would most likely realize value for shareholders, as the value of each individual business would be more easily identified.

There was a question on the Q4 conference call that alluded to the possibility of some sort of divestiture.  Management did not deny it, saying only that it wasn`t an appropriate topic for a public forum.   On the fourth quarter conference call the CEO, Glenn Messina, was asked about the possibility of bidders to the Fleet business (as well as the mortgage servicing business).  His response was:

As it relates to anything regard to Fleet or Mortgage, this public forum is not the place to have any discussions about anything like that. I’m focused on maximizing shareholder value. We’ve laid out our four strategies and that’s what we are going to be pursuing.

That certainly is not a no.

But wait, there’s more!

So a spin-off or sale of Fleet is certainly a possibility.  But that is the not the only source of value hidden within PHH.  PHH is in the business of mortgage origination and mortgage servicing.  The company breaks origination and servicing up into two distinct segments.

Mortgage Origination

Mortgage origination basically consists of finding a person that needs a loan to buy a home, showing that person a list of mortgage options of how they could finance that loan, qualifying the borrower for loan guarantees such as those from the GSE’s, processing the loan (doing all the paperwork) and passing it through to the eventual lender institution (usually to Fannie, Freddie or a bank that will either keep it on their books or sell it to another investor).  PHH takes a cut in the process, or anorigination fee, that is typically between 1/2% and 1%.

Mortgage Servicing

Mortgage servicing happens after the loan is made. The servicer is responsible for determining how much the borrower owes and collecting that amount.  If a loan is not being paid then the servicer takes on additional responsibilities such negotiating a workout upon default, looking after the foreclosed property and such.  There are also other contingent responsibilities such as taxes and insurance, depending on the specifics of the servicing agreement.

The natural hedge of servicing and origination

PHH refers to the servicing and origination businesses as a natural hedge of each other.  Why?  Because they are inversely correlated with respect to interest rates.

Let’s say interest rates fall.  What happens?  People that have mortgages at higher rates refinance those mortgages.  That’s great for the origination business.  They are writing up refi’s and taking in the fees.

Not so great for the servicing business. When a mortgage is refinanced the right to service that mortgage no longer exists.  Of course this can be mitigated if PHH is able to originate the refinance and thus takes on the servicing rights for that refi so the old mortgage servicing right (MSR) is replaced with a new one.  PHH has proven to be quite good at “recapturing” loans in this manner.  But there’s no guarantee.

When rates go up and the opposite situation occurs.  Origination suffers, no one is refinancing at the higher rates.   But mortgage servicing rights are not being lost either, and PHH is collecting cash on these rights for longer.

There are a number of developments happening in the mortgage business right now from which PHH stands to benefit.

Origination: Generating consistent earnings, but needs to grow

Since 2008 PHH has had a steady stream of earnings from the mortgage origination business.   However, probably not surprisingly in the current environment, they have not been able to grow the business substantially.  Below are earnings of the business over the past 5 years, as well as for the first quarter of this year.

I believe there are a few opportunities in the origination space that could change the growth profile of the business  The first is if the company could take advantage of the pricing opportunity that exists in correspondent lending.

Correspondent lending

So first of all, what is a correspondent lender?

Consider the following. Imagine a mortgage broker who develops significant business volume, earns the confidence of wholesale lenders who will authorize him to approve their loans, and has accumulated some capital. He can now obtain a credit line from a bank that can be drawn against to fund loans, repaying the loans when they are sold to wholesale lenders. Under the law, the broker has morphed into a “lender” – the type called a “correspondent lender”.

This has been a business the big banks have traditionally taken a large piece of.   Until now.  In August Bank of America reported that they were exiting the correspondent lending business.  Ally Financial, who lends through GMAC, retreated from correspondent lending back in December before recently announcing that they would get back into the business on a limited basis.  Met Life announcedthat they were winding down their origination business entirely in January.

This isn’t small potatoes.  The above 3 companies were in the top 12 correspondent lenders by volume in the third quarter.

There are rumors others are leaving the business. I thought this quote from a Mortgage News Daily article was spot-on:

One can just hear large lenders talking in their boardrooms. “Do we really want to be in this business, given the regulatory, legal, financial, and public relations issues? Where the value of servicing has dropped dramatically in the market, and could drop further depending on Basel III? Where the mortgage insurance tax deductibility has gone away? Where every week brings a new lawsuit – when will we have more attorneys on staff than originators?”

Its a low margin, highly competitive business.   But the opportunity is that it could become less so with some of the big players moving on.

In the 4th quarter PHH announced that they would be reducing their own correspondent lending business.  But even at the time of the announcement they hedged their bet, saying they would remain opportunistic and take advantages of periods of high margins.  With so many other large lenders cutting back or completely exiting from the business, its a good time to be opportunistic.

Here is what management said about the correspondent business on the Q3 2011 conference call:

Yes I’m going let – yes the answer to the question is yes, we think there are better opportunities but once again we’re really pretty opportunistic in that channel. So we pay close attention to margins in that channel. As you know it’s probably the most cost competitive channel, it is the most cost competitive channel that we operate in and we’ve seen some really strange behavior in that market in terms of where margins are being priced. Some of our competitors are in the market, when they are in the market they’re very aggressive in terms of their pricing and then they back off and they’re out of market and that’s why we stay really opportunistic in that market.

On the Q1 2012 call, when questioned about the outlook of the correspondent business going forward, management began to change their tune.  CEO Glenn Messina said the following:

Right now we think by year end we’ll probably ramp it down to about 20% of the total, but yes, I do want to caution everyone. Last quarter I talked about managing the correspondent operations to a cash budget, and given where margins are today, cash cost origination tends to be very low.

So within the right quality parameters, and we’ve established defined quality parameters around who sells loans to us and the quality of their originations, we may flex up or down depending upon what the cash cost originations is.

So basically what Messina is saying is that margins are so good right now that while we originally figured to be ramping down correspondent lending,we would be crazy to do that in this environment.  Analysts have already ratcheted down estimates for the origination business as a whole based on expected declines in the correspondent segment.   PHH is in a good position to now beat those estimates.

Signing up new partners

The second possible growth vehicle for the origination business is a continuation of the success they had in the latter half of last year in signing up some big partners for their origination business.  From the Q3 CC:

We also made significant progress in growing our nationwide sourcing footprint over the past two quarters signing five new private label accounts. The new relationships include Barclays which we mentioned on last quarter’s call and today we’re pleased to announce that we’ve added Ameriprise and Morgan Stanley Private Bank along with two other financial institutions all as new PLS partners.

PHH did also lose one significant client in Charles Schwab last year, but overall the company expects to gain significant production from the new clients over and beyond the lost ones:

We expect the five new PLS accounts in the aggregate based on their 2011 production and taking into account ramp up time and anticipated launch schedules to produce about 7 billion in closing volume in 2012, about double what we predicted for Schwab.

There haven’t been any further announcements of major partnerships since the third quarter.  I imagine that these relationship get reviewed close to year end, so we will just have to wait and see.  Given the propensity for the big banks to scale back and outsource their mortgage business, it seems reasonable to me that PHH will be able to grow its book through further relationships.

HARP II could provide some short term support to origination

HARP stands for the Home Affordability Refinance Program.  HARP II is the name that has been coined for the new version of HARP.  It supersedes the original HARP.  HARP I was a total failure.

The HARP program has helped far fewer borrowers than its proponents estimated — roughly 894,000 borrowers since Aug. 31, 2011. — and many less than the estimated 11 million U.S. homeowners who owe more than their homes are worth.

Why was it a failure?  A few reasons:

1. Put back risk: Basically when a bank participated in the original program they were worried that they would get stuck with the original mortgage.  I think what happens here is that to rewrite the original loan to new terms, the loan is going to be scrutinized.  The banks and other underwriters know that the quality of many of those original documents are sketchy at best and they would rather not have to pull out the skeletons.

2. LTV Limits: This is probably the biggest problem.  The original HARP program dealt with current loans with LTV’s of 80-105.  That was expanded to 125 in 2009, but that still wasn’t enough.  I was surprised by that until I read this:

This should have a big impact in certain parts of Nevada, Arizona, and Florida where many borrowers owe more than 125% of the value of their homes. In Nevada, for example, two thirds of all loans backed by Fannie Mae are underwater, and half of all loans are above the 125% loan-to-value cut-off.

3. Appraisal costs: the borrower had to have an appraisal done to qualify for the original program.  That appraisal could cost $400.  Borrowers were reluctant to take this cost on when there was no guarantee they would be accepted by the program

HARP II aims to correct these mistakes.  The LTV limit is gone.  Appraisals are no longer required.  And banks are protected against the put backs.Says Brian Ye, analyst at J.P Morgan Chase & Co:

“We are of the opinion that there are enough changes to the program that bank servicers could really change their behavior, and this could be one of the first times that the administration has under-promised and over-delivered,”

There is one particular element of the new program that helps out PHH is that servicers get a head start over third party originators.   I confess I don’t know just what of impact this is going to have, but it is interesting and potentially significant, so I think its worth mentioning.  Servicers like PHH have been writing borrowers up for the program since the beginning of the year.   A third party originator cannot submit any documents to Fannie or Freddie until March.   This was done to entice the banks into the program, but the corrollary is that a company like PHH has been able to capture business up front without the competition.

More information on the new HARP program can be found here.

Will HARP II work?

This is, of course, the big question. The program is aimed to attract two million borrowers by the end of 2013.  This would be a little more than twice what the original program attracted.

However if the program works, and if JP Morgan turns out to be right and the administration “under-promised”, there is certainly a lot of room for upside.  According to CoreLogic:

10.9 million, or 22.5 percent, of all residential properties with a mortgage were in negative equity at the end of the second quarter of 2011.  Eight million borrowers with negative equity, or nearly 75 percent of all underwater borrowers, have above market rates. The disparity is even greater for those with severe negative equity. More than 40 percent of borrowers with 125 percent or higher loan-to-value (LTV) ratios have mortgages with rates at 6 percent or above, compared to only 17 percent for borrowers with positive equity.

Apart from the obvious fact that these numbers show just how staggeringly bad housing has become, if you prefer to see the glass half full those numbers also suggest that there are a lot of borrowers out that could benefit from a program like this.

Mortgage Servicing Rights and the Mortgage Servicing Disconnect

I wrote a long article on Seeking Alpha (The Opportunity in Mortgage Servicing Rights) describing the factors that have caused the mortgage servicing industry to fall into disarray.  I am not going to repeat that thesis in detail here.  To summarize its conclusions by way of analogy, the opportunity in the mortgage servicing industry right now is similar to the opportunity in correspondent lending.   Many of the traditional big players in the industry are getting out of the business and that has left a void.  The void has caused servicing valuations to collapse and has opened up the potential for servicers like PHH to take on new business.

PHH Corp is perhaps not the best way to play the valuation gap in servicing rights.  There are other companies like Newcastle Investments, Nationstar Mortgage Holdings, and Home Loan Servicing Solutions that are actively purchasing 3rd Party portfolios of servicing rights on the cheap, and in my opinion stand to gain substantially from their eventual reversion to historical norms.

PHH, on the other hand, does not buy servicing rights outright from 3rd parties.  They do, however, keep the servicing rights of the mortgages they originate, and they do perform subservicing of portfolios owned by others. It is perhaps in the subservicing business where PHH can take advantage of the exit of other large players, developing new relationships as subservicer.  Right now the subservicing business is a fairly miniscule component of the overall servicing revenue (a little less than 3% of total fee revenue in the first quarter) so I am going to leave this as a possibility, but not one to count on.

The other potential opportunity for PHH lies with the effect rising interest rates will have on its existing servicing portfolio.

Interest rates have done nothing but fall for more than 20 years.

At some point this trend is going to reverse.  Rates are going to head upwards.  David Einhorn published an interesting opinion piece this week in the Huffington Post.  He argued that the Federal Reserves policy of zero interest rates and quantitative easing is counter-productive; that it is not enticing risk adverse investors into stocks.  He goes on to argue that if the Federal Reserve were to allow interest rates to rise, you would see investors begin to shy away from the bond market, as what has been a one way winning trade for 20+ years would show signs of waning.

Falling interest rates have been a plague on the mortgage servicing industry.  Every time a borrower refinances, the servicing right associated with the original mortgage ceases.  This has put companies like PHH on a treadmill of generating originations to replenish their servicing pipeline, and forced them to work hard to recapture the borrowers that are looking to refinance.

When interest rates begin to head back up, the opposite scenario is going to prevail.   PHH is going to be left with a servicing portfolio that is chaulk full of low interest rate loans that will not refinance for years.  Everyone who can refinance their mortgage will have already done so.  Meanwhile, the quality of the loans being originated since 2008 is some of the highest it has ever been.  No one has dared make a risky loan in the current environment.

There are 3 risks associated with holding a mortgage servicing right.  The first risk is the risk of refinancing.  The second risk is the risk of default.  The third risk is the risk that the house is put up for sale.  We are in an environment where the first two risks are likely to be lower going forward than they have been for quite some time.  A rise in the risk of the house simply being sold implies an economy that is recovering.   Thisis probably a positive for PHH, as higher home sales will drive it origination business.

The end result is that the servicing portfolio that PHH owns is going to be generating cash for longer than it has in the recent past.  This is going to help PHH grow its portfolio further, for the simple reason that the portfolio won’t have as much turnover.

A brief look at the effect of mortgage servicing rights on tangible book

Another effect of rising interest rates is that which it will have on the book value of the servicing assets.

PHH provides an estimate of its tangible book value every quarter as part of its investor supplementary material.  Below is the estimate at the end of the first quarter as well as at year end 2011.

The company is trading at a reasonably significant discount to tangible book, which in itself says something about the unrealized value.  But if you look at the book value a bit closer, you realize that there is a lot of hidden value within the assets on the books.

Baked into shareholder equity is the value of the mortgage servicing assets that PHH carries on their balance sheet.  The servicing asset was carried at $1.3B at the end of the first quarter.  As I already explained, this asset is marked to market every quarter based on interest rates and the perceived threat of prepayment and default of the mortgages underlying the asset.   The asset represents the future value of servicing an unpaid principle balance of $149.6B in mortgages.  According to the latest earnings release, the average yearly fee that PHH receives for servicing those mortgages is 30 basis points, or about $450M of servicing fees per year.  A simple ratio comparing the current value of the servicing right ($1.3B) to the expected income of that portfolio ($450M) tells you that PHH is valuing their servicing portfolio at about 2.9x its yearly servicing income.

I’ve done a bit of research into the matter, and while right now mortgage servicing rights are selling at multiples of anywhere from 1x to 3x the yearly income, in the past servicing rights sold at 4x to even 6x yearly income.  Once servicing rights return to the mean, the book value of PHH will rise substantially.  At 4x servicing book value would rise byapproximately $450M to $34 per share.  At the high end of 6x book value would be $50 per share.

Another way that higher rates help servicing revenues

There is another rather obscure way that higher interest rates are going to improve earnings at PHH.  As part of the mortgages that PHH services PHH is charged with managing escrow accounts that are used to hold funds designated for taxes and inusurance.  PHH receives a benefit for these services by way of receiving the interest on these accounts.  The interest benefit is recorded under the Mortgage Servicing segment accounting item Mortgage Interest Income.

Beginning in 2008 mortgage interest income collapsed.  Since then it has fallen to a fraction of what it was pre-2008.

Taking a look at the PHH 10-K for 2008, when the collapse began, PHH said the following about the reduction in mortgage interest income.

Mortgage net finance income decreased by $86 million (89%) during 2008 compared to 2007, primarily due to lower interest income from escrow balances. This decrease was primarily due to lower short-term interest rates in 2008 compared to 2007 as escrow balances earn income based on one-month LIBOR.

As interest rates rise, the interest associated with these escrow accounts are going to rise substantially.  In 2007 one month LIBOR averaged around 5.3%.  In 2011 it averaged around 0.3%.  When (perhaps if) the economy finally begins to show some strength, LIBOR rates will rise.  To give a sense of this affect on PHH, in 2007 PHH was pulling in almost $3/share worth of revenue from these escrow accounts.  In 2011 that had dropped to $0.30 per share.

The Fannie put back

Since 2007 PHH has had a continual drag on its mortgage servicing income caused by the put-back of mortgages from Fannie Mae.  Over the past couple of years Fannie Mae has been reviewing their loan book for the periods from 2005-present and looking for any breaches in contractual terms, poor underwriting or defective documentation.  When it finds a mortgage that has one of these flaws, it puts it back on the lender.

PHH can fight these repurchase requests, but only up to a point.  Bank of America has been probably the most vigilant in fighting Fannie, and in return Fannie decided not to renew their contract to buy loans from BoA.  Fannie holds the trump card in this battle, and so PHH is going to be pretty much stuck with paying up for many of the repurchase requests put back to them.

Since 2008 PHH has been taking significant writedowns due to the repurchase requests including a big charge at the end of the most recent quarter.

The topic was discussed in depth on the first quarter conference call.  Messina had the following comments:

Based on our ongoing discussions with the GSEs, we believe that by the end of 2012, they may be substantially complete with their review of our seriously delinquent and defaulted related to origination years 2005 and prior, and by the end of 2013, they may be substantially complete with their review of our seriously delinquent and defaulted loans related to origination years 2008 and prior.

Almost 78% of our standing repurchase requests at quarter end are related to the 2005 through 2008 origination years. Given the results of the first quarter, our ongoing discussions with the GSEs, we believe it’s reasonably possible that future losses related to repurchase and indemnification requests may be in excess of our recorded foreclosure-related reserves.

Assuming that the elevated level of repurchase demands that we have recently experienced continues through the end of 2013, and the company’s success rate in defending against such requests declines, and that loss severities on repurchases remain at current levels, the estimated amount of possible losses in excess of our foreclosure-related reserves is $140 million.

The bottom line is that repurchase requests are likely to be a drag on earnings for the next two years.  The company is outlining $140 million in addittional charges, presumably broken up over the next 7 quarters.  This works out to about $20 million a quarter, which is fairly consistent with the level of charges over the past 3 years.

When core earnings matter

Whenever a company publishes core earnings you have to look good and hard at why they are doing so.  You never know what they might be trying to gloss over by eliminating some of the more unsavoury elements of the income statement.

PHH reports core earnings every quarter but they do so for a very good reason.  Core earnings are a far better representation of the company’s profitability than are GAAP earnings.

The problem with GAAP earnings is that they are obscured by changes in the mark to market value of the mortgage servicing right portfolio.  The accounting nature of the servicing right is such that PHH has to write up and down the mark to market value of each right with changes in interest rates.  A servicing right is in many ways no different than an interest only mortgage security.  The biggest risk is the prepayment of the security and with most mortgages this risk is closely tied to interest rates. When rates go down mortgage servicing rights have to be written down in value to reflect this increased risk of prepayment.

The fluctuations on the income statement caused by these mark to market moves are huge.  Up to $400M in some quarters, which for a company the size of PHH (there are only 55M shares outstanding after all), leads to massive moves up and down.  If you look at quarterly GAAP earnings over the past couple years they look like a scatter chart.  Below is a chart of earnings from the mortgage servicing segment that includes the effects of the mark to market adjustment.  With interest rates having fallen so precipitiously in the last few years, PHH has had to take pretty massive GAAP writedowns on their servicing portfolio.  Below are the before tax earnings per share from the mortgage servicing segment.  Much of the swing is the result of the mark to market adjustments to the servicing portfolio.

The reality of the mortgage servicing right is that as long as the company is replenishing the existing pool with more rights from new originations and recaptured refinances then its losing to payoffs, its all good.  As I already noted, PHH is doing that and then some.

The core earnings number that PHH reports is quite simply GAAP earning less this mark to market effect. And if you look at that core earnings over the last few years you can see that they have have been growing consistently and that the current stock price of $17 is not expensive relative to earnings.

So what did Bass see?

Let’s review the core elements of the thesis with PHH:

1. The company is trading at about 65% of a tangible book value that perhaps undervalues the servicing assets by 25-50%
2. Core earnings, which are a relevant metric of company profitability, are over $3 per share and growing
3. The Fleet business itself has the potential to earn $1 per share in 2012 and provides a reasonably steady earnings stream even during recessions
4. There is upside potential for PHH to take advantage of the current disconnects in the mortgage market, both in servicing and in originations
5. The potential of a divestiture or spin-off of Fleet from Mortgage or vice versa

The downside is that the stock has moved well off its lows and that because of the sensitivity of the mortgage business to overall economic activity, the share price is volatile.  Bass bought his shares at around $10 and in full disclosure I bought most of my shares in the $12 range, though I have added recently with the break-out above $16.  While I can’t say for certain that PHH will eventually divest the Fleet business, I think that the story has enough elements that even if they don’t, there is plenty of room for upside appreciation in the share price.

PHH Corporate Presentation

I think this (Ryan here) is a situation where it helps to understand recent changes in context of history, and I think its actually critical to putting all the pieces together and connecting the dots, so I would recommend heading over to Value Investors Club and reading the handful of older write-ups for further context and understanding, as well as the Pennant Capital 2009 proxy statement embedded below.

I thought we’d start with Kevin Lin’s recent presentation from a few week’s back, where I think he frames/breaks down the opportunity and risk/reward equation in a particularly insightful fashion. Kevin’s an associate at a family fund and an avid phillanthropist and a noted small cap junky in his spare time. We’re grateful to Kevin for making this available to our readers. It’s great stuff!

While I’m more optimistic regarding Thunderbird and Donner (part 3 may be the best yet) and plan to add a few additional thoughts/insights of my own around the edges of his presentation soon, I thought his work was unusually good.

Although somewhat dated, anyone looking for insight on how think about thinking about the power and nature of the stream finance business model needs to read this wonderful piece of analysis from 2009 (on Royal Gold) by Murray Stahl. Might want to read it twice and again for good measure.

Last but not least we have Connor Haley’s valuation piece that takes his cue from Murray’s valuation methodology. Connor is a student at Harvard, and a former analyst of Osmium Partners and the Motley Fool who – along with his colleagues Geoffrey lee, John Capodilupo, and Roman Yevstihnyeyev – put together this piece on valuing the optionality of the streaming contracts. As he put it, “It is pretty complicated-as it is not just a simple option, especially once you start factoring in the option of the minimum payments as well. I essentially wanted to be AS CONSERVATIVE as possible-and see if there is any way that this stock could be overpriced. Even with our most conservative assumptions for mine life for their various projects, the value of the equity (contract value + net cash/ fully diluted shares outstanding) was $0.74″

While I’m more off a back of the envelope type of guy, the valuation work here is top notch and along with Kevin’s presentation above, points to more of the same – SND remains priced substantially beneath any reasonable estimate of its intrinsic business value.

Enjoy!

The investment analysis below is our fourteenth in our ongoing series of guest posts, and is brought to you by friend of the blog John Rolfe of Argand Capital Advisors. Since founding Argand in 2001, John’s gone about the last 11 years employing a global, long/short approach focused on “quality-driven, event-based value investing” to the substantial benefit of both himself and his partners. As someone whose followed John’s work for years, I can’t say I’m surprised given what appears to be an uncanny knack for discovering early stage franchise opportunities at valuations that imply anything but. As the write-up below helps to demonstrate, finding and exploiting great businesses at excessively attractive prices is what he does best.

I did want to note that this is a guest post that’s been a long-time coming considering how many times we’ve bumped into each other in various position’s we’ve held over the last few years. My working theory up until this point is that we appear to share a similar weakness for the siren song of grossly mis-priced perpetual compounding machines (as such calls in my experience tend to attract like minded investors like bees to honey). So I wasn’t the least bit surprised to discover John was also a fellow traveller on the back of the 700lb Boyd Group Income guerilla. You know what they say, once you’ve gone a few rounds with a wonderful business at a throwaway price, its hard to go back to anything but.

In that context then it’s a long overdue pleasure to share John’s latest (outstanding) write-up on Boyd Group Income. For those who aren’t familiar, Boyd is the first to bring Walmart like scale to the auto collision & glass repair space. As is customary for the biggest, best, and most efficient (garage) network in a highly fragmented market with abnormally attractive consolidation economics – this hugely advantaged, high quality business should continue to go about its business stealing share, growing its top line at an above average rate and experiencing steadily improving operating efficiency in the process for a long time to come.

Enjoy!

Thesis:

Boyd Group Income Fund (“Boyd Group” or the “Company”) is a Canadian-listed income trust that operates the largest network of automobile collision repair shops in North America.  The Company currently trades for roughly 8x projected 2012 cash EPS (cash EPS defined as reported operating EPS plus a favorable D&A/capex spread of roughly C$3mm).  This is an extremely attractive multiple for a business with strong long-term demand dynamics driven by secular industry changes, material incremental growth potential through roll-up opportunities, strong free cash flow characteristics, outstanding cash returns on both invested capital (>20%) and equity (>40%), and a financially conservative management team.

Boyd Group has over 175 locations, split roughly 80%/20% between the United States and Canada.  These locations, spread among 14 states and four Canadian provinces, operate under a number of different brand names, including Boyd Autobody & Glass, Gerber Collision & Glass, True2Form Collision Repair Centers, and Master Collision Repair.  The Company is currently in the process of standardizing a number of its brand names, particularly those that are the result of recent acquisition activity (True2Form and Cars), which will lead to more uniformity in its national brands.

The North American automobile collision repair industry is highly fragmented.  With total annual industry revenues estimated between $30 and $40 billion, the top 10 operators have an aggregate market share of less than 5%.  As a result of this fragmentation, insurance companies, which pay for the vast majority of collision repair, have historically had to deal on a local level with an overwhelming number of small, independent operators.  This dynamic, however, has begun to change in recent years with the introduction by insurance companies of Direct Repair Programs (“DRPs”).  Through a DRP, the insurance company steers their policyholder to an approved repair provider.  By running a higher percentage of repair business through these approved providers, insurance companies can typically ensure both a higher level of quality control and more consistent pricing, while decreasing their administrative overhead.  The growth of DRPs has been a consistent driver of market share shifts over the last several years to the larger operators like Boyd Group, providing a nice boost to same store sales.   SSS results can be volatile Q to Q as a result of weather (i.e. particularly inclement winter weather drives growth in accident incidence, thereby benefiting Boyd, for instance); however, this volatility tends to average out over multiple seasonal cycles.  SSS growth for Boyd Group over the last few years has typically hovered in the mid-high single digit range, primarily as a result of market share gains.

From its founding roughly 20 years ago, Boyd Group has been built through a combination of both organic growth and acquisition.  The Company went through some growing pains in the 2005-06 time frame, at which point it ceased all acquisition activity and refocused its energies on optimizing the existing operation.  Concurrently, it worked to improve its balance sheet by halting dividend distributions and devoting free cash generation to paying down debt.  At the time, this was viewed by the existing shareholder base as a materially negative development.  The Canadian income trust structure was originally designed to incent the underlying companies to pay out a significant portion of their cash flow as dividends (similar to a U.S. REIT structure), so many of the income trust shareholders put a high premium on dividend yield, and were disappointed with Boyd Group’s dividend discontinuation.

Although shareholders were unhappy, management’s conservative approach to the dividend policy facilitated a reasonably rapid improvement in the Company’s financial profile.  The Company reinstated a dividend in late 2007, and consistently increased it in-line with continued improvements in financial performance through 2009.  At this point, management felt that the Company’s financial health put it once again in a position to look externally for growth opportunities.  As a result, the Company subsequently sourced and closed two material acquisitions: True2Form Collision Repair Centers in August 2010, which added 37 new locations, and Cars Collision Center in June 2011, which added another 28 locations.  Both of these acquisitions have brought a material base of new locations into the Company that, at the time of acquisition, had been operating at profitability levels materially below Boyd Group’s corporate average.  As best practices, purchasing efficiencies, and corporate overhead leverage are gradually realized, improving profitability at the acquired locations should provide a decent tailwind to continued earnings growth.  More recently (early 2012), Boyd Group closed on a smaller multi-location deal in Florida, Master Collision Repair, Inc. (“Master”).  Master brings an additional eight locations into Boyd Group, in a particularly attractive market with very little competition from other large multi-location collision repair providers.  On its most recent earnings call (4Q 2011), Boyd Group management commented that while there are not seeing a significant number of large multi-location deal opportunities, the environment for small to mid-sized deals is “as favorable as we’ve ever seen it”, and pricing on these deals has been consistently improving.

Working capital needs for Boyd Group’s business are modest.  Parts are typically ordered as-needed for repair work, which ensures only a limited required investment in inventory, and with 90% of revenue generated from insurance companies (as opposed to individuals) receivables are paid promptly.  Moreover, in exchange for exclusivity with its paint supplier, Boyd Group receives prepaid rebates from this supplier that further reduce net working capital requirements and contribute to cash flow.  These favorable working capital dynamics, in addition to limited ongoing capital expenditure needs, help drive a consolidated cash return on invested capital of over 20%, and a cash return on equity of over 40%.

Returns on Boyd Group’s growth investments are attractive as well.  The Company generally targets a 25% pre-tax return (or 20% after-tax) within the first couple of years for both organic growth opportunities and acquisitions.  The Company targets a 6-10% annual growth rate in greenfield locations, with an additional growth boost from acquisition activity.  Boyd Group’s exclusive paint supplier has typically provided favorable financing on acquisitions in exchange for its exclusivity, helping ensure that these acquisitions are accretive to earnings, cash flow, and intrinsic value.  A portion of this supplier financing is typically forgivable, effectively providing a subsidy and a net reduction in purchase price to Boyd.

Boyd Group has a favorable spread between its D&A and capex of somewhere between C$3mm and C$6mm (C$0.23-$0.46/shr).  Amortization of acquisition-related intangibles currently runs at roughly C$2.5mm/annum.  Management has historically guided to a maintenance capex level of 80bp of sales, which would have equated to a bit less than C$3mm in 2011.  Compared to a 2011 depreciation charge of C$6.3mm, this would imply a roughly C$3mm favorable spread between depreciation and maintenance capex.  The favorable spread is driven by depreciable lives for the Company’s relatively simple PP&E (paint booths, buildings) that are materially shorter than those assets’ economic lives.  Note, as well, that unlike investment pitches that rely on “maintenance” capex that bears no real-world relationship to a company’s actual capex, Boyd’s capex in each of the last few years has been running materially below the actual level of capex.  This gives me comfort that the favorable spread is real, and sustainable.

For 2012, C$440mm in revenues should be achievable.  While this represents a health 23% growth rate over reported 2011 revenues, roughly 80% of the growth can be accounted for by annualization of the June 2011 Cars Collision Center acquisition, the early 2012 Master acquisition, and already-completed single location acquisitions in 2012 (three year-to-date).  A 5% SSS comp accounts for the balance.  On margins, a modest 20bp lift over 2011 levels would imply an EBITDA margin of 7.0%, and aggregate EBITDA of $31mm.  Although margin expansion should be more robust in future years, the relatively material amount of ongoing M&A integration activity in 2012 will limit this expansion in the near-term.  $31mm in EBITDA should translate to $24mm in EBIT and $22mm in pre-tax income.  Using a blended tax rate of 26% (despite having most of its operations in the U.S., the Company retains a material tax benefit from its income trust structure) yields $16mm in net income.  On 13.3mm shares, this in-turn implies C$1.20 in reported EPS.  The favorable D&A/capex spread adds another C$0.25/shr for a cash EPS number of C$1.45/shr.  Versus the current C$11.60 share price, you’re buying the Company at just 8x cash EPS.  Boyd Group currently pays a monthly dividend at an annual rate of C$0.45/shr, for a yield close to 4%.

With respect to risks, there are several.  1) The collision repair business is economically sensitive.  Although market share gains in recent years for Boyd Group have masked this sensitivity, in times of economic hardship consumers tend to repair their vehicles less frequently, and drive fewer miles, both of which decrease demand for collision repair services; 2) Near-term, results for Boyd Group will likely be somewhat weak.  The extremely warm winter weather will negatively impact Boyd’s SSS in is cold weather markets (Chicago, Denver, U.S. northeast) for 1Q 2012, and possibly in to 2Q 2012, and it’s likely to post down comps (as guided on its most recent earnings call); 3) Last of all, input cost inflation is a concern.  Paint costs have been rising in recent years, and price increases generally lag cost increases in Boyd Group’s business.

Miscellaneous:

Boyd’s Q4 Presentation

October 2011 Roman Report

Kuppy’s latest post is peppered with insightful observations and various pearls of wisdom as it relates to Energold’s Q4 results.

My personal favorite…

“if you live and die by one quarter, you’ll get chopped to pieces.”

Enjoy!

Figured I would lighten things up a bit. While I came across a variety of amusing april fools jokes, I thought the three links below were particularly laugh out loud worthy. Enjoy!

Velocity Shares Launches New Super Zero ETN Designed to go to Zero Faster Than any Existing Product

The No. 1 Reason to Invest in The Motley Fool IPO

Baker Street Capital’s Letter to the Board of Berkshire Hathaway

Fascinating work done by the guys over at Empiritrage

(H/T Phil from The Book Book Fund Blog)

A little late, but better late than never…

Deja Vu All Over Again

“Wisdom is learning what to overlook”

-       William James

“…a fiery growth engine, the kind of business we like to own: one that doesn’t require enormous sums of cash to generate annuity-like cash flow”

-     Sardar Biglari

Introduction:

For part 2 of the ongoing review of the high quality assets backing Sandstorms M&E streaming portfolio, I want to turn our attention to Sandstorm’s flagship Metallurgical Coal assets. I’ve chosen to follow up with the met coal deals primarily because I think that they offer yet another powerful illustration of the fact that SND’s highly attractive streaming assets can be purchased at a price that is by any rational measure completely out of proportion to economic reality, and almost certainly unsustainable assuming pretty much any future scenario where the world doesn’t actually end.

So, without further ado let me introduce you to NovaDx and its low cost, long-lived high quality metallurgical coal play(s), the Rosa and Rex No. 1 mines. Like with nearly all of SND’s streaming assets, the potential to increase value above and beyond the initial 2013 reserve/production estimates is substantial (to say the least) and the potential for a true moonshot type of homerun when all is said and done is very, very real. Of course, I would do a disservice to not mention that SND shareholders at current prices are quite literally paying nothing for this high probability, heads I win, tails I don’t lose call option on high quality silicon based met coal, so definitely keep that in mind as we go.

My hope is this latest rational walk will highlight the above reality and in the process, provide the breadcrumbs that ultimately persuade other bargain hunting investors to really roll up their analytical sleeves so to speak and do the work necessary to get to know these assets, their respective competitive/cost positions, the guys running the show, and last but not least, to come to a firm conviction as far as what is, and is not, an appropriate valuation after weighing all of those factors. While I’m not certain of many things, I am certain that the price implied expectations are one thing, but reality here is another – and so I think the real rewards (as always) will accrue to those that can tell the difference and position themselves accordingly.

So lets get to it.

Thoughts on the Silicon Metallurgical Coal Market

Before I begin I want to note that I’ve chosen to focus on the silicon coal aspect of this story as opposed to met coal utilized in the coking and activated carbon markets, primarily because the vast majority of the potential value creation here resides in the continued development of SND’s Rex No. 1 stream and the high quality silicon coal it produces. For those who aren’t familiar with silicon coal and its uses, silicon is a key input in silicon metal and hence by extension in thousands of industrial and consumer products unrelated to steel production – typically within the chemicals and aluminum industries. So I think its crucial to understand this nuance, as NDX – and SND by extension – and its Rex No. 1 mine is well positioned to capitalize on the anticipated growth and widening supply/demand imbalance of silicon coal over time.

Keep in mind that demand for Silicon metals is a secular growth story that is both firmly intact and driven by a confluence of global macro “mega trends.” These “mega trends” make silicon coal somewhat unique amongst the coal family, given it possesses multiple sources of end market demand. Much like the difference between silver and gold, silicon coal’s supply/demand dynamics are driven by multiple uses in more a more varied set of end markets. The takeaway is that pricing isn’t solely reliant on the relentless shift of China’s rise as the economic center of gravity as far as the consumption of met coal is concerned. This is an important and salient point to understand as far as thinking about the value of these streams long-term to SND and the associated supply/demand dynamics (and hence pricing) of the silicon coal that is produced. Granted, concerns over the pace of growth in China, the European financial crisis and the strength of the U.S. recovery have caused downward pressure on steel demand. Yet, even with these short-term concerns, U.S. coke plants are running near capacity and global steel mill percentage utilization remains in the mid-70s. With seaborne metallurgical coal demand expected to grow by more than 170 million tonnes to 428 million tonnes by 2020 (which is nearly 70 percent higher than the 2011 level) clearly the long-term fundamentals are still in tact.

What is not as well known are high quality silicon coals other industrial uses/underlying drivers, and thats a big part of this streams story. Consider silicon coals role in the production of silicon metal, which is the key component in the production of silicon chips and therefore everyday electronics. The increasingly global focus on renewable energy & energy conservation is another big piece of this puzzle that is expected to continue to benefit silicon producers and their bottom line.

For example, the use of silicon metal in aluminium alloys makes it both stronger and lighter. As a result, silicon metal is a key component in the aluminum that is being increasingly used in the automotive industry in order to replace heavier cast iron components. The benefits of this transition are obvious, as it allows car and other vehicle manufacturers to garner weight reductions. This leads to less fuel consumption and increased efficiencies and hence benefits the environment by both reducing greenhouse gas emissions and conserving fossil fuels. This is a trend thats here to stay.

Other drivers of the increasing demand for Silicon Metal (and hence silicon based coal) come from (1) the solar power industry – as solar panels are made from silicon, which use the sun’s energy to produce domestic and industrial electricity and (2) silicon based polymers – which are used as alternatives to hydrocarbon based products and appear in many other every day staples such as lubricants, greases, resins, skin and hair products. So while this is not meant in any way to be a comprehensive overview of the end markets and/or the underlying supply/demand equation that should support silicon coal pricing, I did want to briefly discuss the issue in order to highlight that numerous secular tailwinds are supporting the value of SND’s Rex No. 1 assets long-term. Taken together the tailwinds here are VERY powerful, not entirely dependent on Chinese consumption, and unlikely to relent long-term for obvious reasons, so the fundamental underlying reality governing the supply/demand imbalance of silicon coal appears here to stay and I think its reasonable to expect a stable to rising price over time.

In sum then, who knows what pricing will look like over the next year or two or how much met coal China will need to import in the meantime. I certainly don’t. Our downside here is well protected either way and the good news is that I don’t think one has to know the answer to that question anyway – at least if we’re patient, long-term investors evaluating a 2-3 decade premier coal asset with a long-term time horizon in mind.

Long-Term Contracts

I would also be amiss if I didn’t mention another attractive attribute of these assets that I believe is relevant in regards to thinking about the intrinsic value of SND’s stream(s), especially in context of the cyclical nature of all commodity assets generally and there potential vulnerability to external shock. Investors should understand (and appreciate) that high quality silicon producers can, and usually do, strike long-term contracts with customers for all or at least a portion of their expected production (think manufacturers of silicon metal).

As a sucker for stable, predictable cash flows with a high degree of visibility, I honestly can’t help but do a little dance when I think about this – as the combination of (1) SND’s locked in low fixed costs and well covered economics with (2) the cash flow visibility provided by long-term contracts, should will provide SND with what will be an unheard of combination of outsized and growing cash margins on production volumes coupled with a degree of cash flow stability that is honestly something approaching perfection as far as the typical commodity producer is concerned (so eat your heart out upstream MLP’s!!! Ha!).

I think its fair to say that the combination of low cost assets, sound financial footing, and long-term contracts is as close to a match made in heaven as it gets in this business, and honestly goes along way towards neutralizing the negative effects associated with the cyclicality of met coal or commodity pricing generally. I don’t say that lightly, but the reality is that we are talking about an asset (1) with well covered economics given its low cost operations which, almost by definition, should allow the asset in question to generate consistently positive cash flows over a full cycle. If you toss in long-term contracts into that equation, the assets vulnerability to external shock is lessoned materially (2) that is owned by a producer that is – and should continue to be – well financed thanks to the financial fortress that is SND.

In commodity investing I think owning marginal (i.e. assets that aren’t low cost) is a really bad idea generally and – at least in my experience – one of the best ways on the planet I’m aware of to both (A) lose money  and (B) suffer sleepless nights. Not my cup of tea. Again, as someone that’s learned the hard way (twice no less!), I think its critical to insist on only owning assets that are low cost in nature and possess balance sheets that are strong enough to safely withstand a long period of low commodity prices – otherwise the company in question may be forced to liquidate assets or raise equity at the absolute worst possible moment. It’s just not worth it. Ever. That, and if your trying to get leverage to commodity x, there are much better ways to go about it than owning the equity of some high cost producer that’s loaded with debt. So what I’m saying is that we have the best of all worlds with these streams as the presence of low cost deposits, long-term contracts and a strong financing partner augment the MOS to a level that’s usually not possible in resource assets and for that I’m thankful. And it’s also no small point that SND’s fortress like financial strength and win-win partnership approach provides NDX with both the financial flexibility and firm financial footing necessary succeed long-term as it allows them to both better deal with the occasional “out of left field” kick in the balls (that is part and parcel of all capital intensive commodity businesses) as well as a healthy amount of negotiating leverage when negotiating contracts with customers. All in all, the odds of success seem highly skewed in our favor.

Thoughts on NovaDx Ventures: More Than Meets The Eye

Before we dig in to the assets, I wanted to do a quick overview of Sandstorm’s partner NovaDx Ventures. For those who aren’t familiar with NDX yet, they are a Vancouver based mining investment company that owns the Rosa & Rex No. 1 mines and the companies primary focus is to acquire and develop companies with active or near production high quality coal reserves within the US Appalachian coal region. NovaDx’s goal over time is to continue growing its “specialty” coal business through expanding production organically at its existing mines as well as through the opportunistic pursuit of value accretive acquisitions.

Per the company’s website…

“In October, 2006 new management lead by Neil MacDonald, Novadx’s CEO took over Novadx and the company began operations as a merchant bank with an investment focus in mineral exploration. The company structured, made investments as a principal and provided management and other related services to companies and projects that it believed had an above average opportunity to provide a high return on investment. During this time the company acquired and expanded the Canadian Small Cap Resource Funds, a family of flow through funds, which was subsequently sold in June 2009.

In October 2008, Novadx changed its investment focus to concentrate on acquiring and developing high quality coal reserves and operations in the Appalachia coal region of the USA and incorporated its wholly owned subsidiary MCoal Corporation to commence the property acquisition, permitting and development of the Company’s flagship Rosa Mine in Blount County, Alabama. Novadx commenced production of high quality metallurgical coal at the Rosa Mine in April 2010. In November 2010, Novadx arranged up to $38 million in funding by way of a coal stream financing with Sandstorm Metals & Energy of Vancouver, BC”

So, we have a CEO who is a former financier who used to run a merchant bank, but decided that the Rex and Rosa opportunities were worth effectively winding down his merchant bank business in order to focus solely on the development of those assets. Interesting to say the least. Of course as a focused opportunist myself that sees what he sees (just do the math), I can certainly relate.

Now I’ve never spoken to Mr. McDonald personally, but from what I can gather he seems to be about as non-promotional as it gets given the minimal publicly available information on both his previous firms history, and more importantly on NDX and its assets generally (as the company doesn’t even have a presentation on its website or an IR representative – at least the last time I checked) – so its hard to size him as I normally would. That said, from the few things I do know I’ve been impressed, and I trust Nolan’s instincts and overall process thoroughly anyhow, so intuitively I think we’re in good hands here.

As far as what specifically impressed me, it was the way McDonald went about building the business from the start. In particular, how he patiently poached various top local executives in order to build a deep bench that appears to possess both (1) a distinguished track record and (2) a truly intimate familiarity with what it takes to successfully operate within both the Appalachian coal belt (and Tennessee and Alabama in particular).

Another salient signpost in my mind has been his strategic decision to focus on specialty coals – or put differently – on only higher margin subsets of the coal industry with structural supply/demand imbalances (nice and double nice!). So while I withhold a definitive opinion for now, I think its fair to say that clearly this isn’t your typical early stage natural resource management team. I mean it’s been built by a guy that for all intents and purposes did it through the acquisition of local all-stars (genius) and with a focus only on stable, higher margin niches with attractive long-term pricing dynamics (common sense). Two very savvy moves no doubt.

All in all then, given his history as an investor and financier, and taking into account his execution so far at Rosa and Rex, not to mention the way he built his team and shaped its strategy, again, it appears things are quite good in respect to the individuals leading the charge. At the very least he appears to be a capable leader that understands how to intelligently build and operate this type of business as well as capital allocation and competitive strategy – a convergence of characteristics that – lets be honest – is exceedingly rare in the industry (we are, after all, talking about an industry dominated by C-level execs and geologists that historically has proven adept, no freaky good actually, at the fine art of shareholder wealth immolation). That, and I seriously doubt Nolan wouldn’t be extremely picky about the team he chose to back the development of Sandstorms flagship (and originally only) asset. Again, I think we’re in good hands and that’s a critical point.

The Rex No. 1 Mine: Underground Mine located in Campbell County, TN

With the backdrop out of the way, lets switch gears and turn our attention to the actual assets underlying Sandstorms coal streams and in particular, its crown Jewel, the Rex No. 1 mine located in Campbell county, TN. This is where it starts to get good.

As I alluded to earlier, the Rex seam is known for its high quality metallurgical coal; a high volatile A bituminous coal with very low ash, very low sulphur, and high British Thermal Units content that is often used in the production of silicon metal. The Rex deposit is located in one of the most attractive coal mining districts in NA and notably sits on one of the largest single continuous resources of metallurgical coal located in the Central Appalachian coal belt. Historically, high quality metallurgical coal has been mined in the area surrounding the Rex No. 1 deposit since the early 1900′s and was traditionally sold as metallurgical “coking” coal. Since 2004, the Rex coal has been sold primarily for the production of silicon metal due to its high quality and low iron and titanium content.

What we have here then is more of that Watson’s family special sauce we observed in Part 1 with Sandstorms Gordon Creek natural gas stream. Like Gordon Creek, the Rex deposit is indisputably high quality, long-lived, and currently under development in a premier location with (A) consistent and well known regional geology and (B) substantial infrastructure (and access to ports) already in place. Also like the Gordon Creek stream, this asset is (1) run by a seasoned, locally connected management team with (in this case) over 100 years of cumulative experience in both the coal and capital markets (2) low cost operations and (3) a “high impact” opportunity to expand the resource base with a simple and well known playbook. The similarities don’t stop there either, as it’s also entirely reasonable to assume that management is capable, and will ultimately succeed in their goal of ramping Rex’s normalized production volumes to a level vastly higher than the initial run-rate. And again, were talking about basic blocking and tacking here (i.e. a combination of increased drilling and increasing the lease area in the immediate vicinity). Basically it’s just more of the same, and why my mess around with a perfect recipe anyway? “Perfect” may be a little strong but clearly the odds are stacked in our favor, and let’s be honest, that’s what its all about is it not?

Anyhow, the Rex No. 1 Mine is still undergoing development and is expected to begin production during the third quarter of 2013. As you would expect, managements got lots of wood to chop between now and then. Which, now that I think about it, is probably why they don’t have a presentation or why they don’t appear to have a scintilla of interest in promoting the stock at this point. Frankly, now is not the time in my opinion and honestly view it as another sign we’re dealing with capable individuals here. So ongoing construction at the mine is considerable at this point, including surface infrastructure, development of additional mains to support future operations, rehabilitation of access ramps and preparation of underground mining equipment. Think of it like a bunch of bees preparing the hive in order to ensure that it will hum in perfect harmony.

So what’s it worth? Well, I’ll break it down in the valuation section below but lets just say there’s a decent chance that Rex is Sandstorms most valuable asset, in which just like Gordon Creek, the NPV of all future cash flows is likely worth more than the current enterprise value of Sandstorm as a whole. With an initial production run rate of 450-500k tons per year and a 2p reserve value of ~39m tons, this thing has the potential to become a cash producing monster once it grows up. Think about it like this, barring a substantial increase in annual production, current reserves dictate a LOM ~78 years!!” Call it the “super long lived, long-lived asset” if you will. From a cash flow perspective, assuming a flat silicon coal price (so a ~115 cash margin/ton) and zero increase in mine resources (both ridiculous assumptions), Rex would generate ~$14.3m to SND every year for the next several DECADES. Read that twice.

Remember, you can theoretically purchase the whole enterprise today for ~100m. Lets take a moment to think about how crazy this is, as even if we assume flat prices, no resource expansion, a conservative recovery rate and in one last fit of insanity decide to zero out the entire rest of SND’s current – and hugely valuable – existing streaming portfolio and assume they never do another deal – even then – we would be purchasing what I think is intellectually valid to characterize as a fully covered, 40+ year senior secured bond with an implied ~15% annual yield, where that yield is highly probably to grow substantially over time. Now if that doesn’t put it into perspective for you, you should probably just stop reading now. Not to beat a dead horse, but this business at this price is a GIFT.

The Rose Mine: Auger & Strip Met Coal mine in Alabama:

The Rosa Mine in Alabama is a currently producing auger mine and is expanding its strip mining operations in addition to increased auger mining operations. Construction of the Rosa wash plant was recently completed and is now entering the commissioning phase, increasing its recoverable coal yield to 90%. Notably, NovaDx had previously stockpiled a portion of its coal production, in anticipation of the wash plant becoming operational, and has recently begun processing this coal through the new facility for sale to market.

I’ve chosen to keep the analysis light on Rosa given its value is a secondary consideration in the context of Rex. Readers should feel free to ask any questions about the Rosa mine in the comments section below. That said, annual expected production is approx 150k tons/yr with on-going cash costs of $75. At 150k oz of production, Rosa’s current LOM sits @ ~3.5 years but is expected to reach ~12 years after Rosa is fully proved up and developed. SND’s streams cover the first two phases.

Now to the valuation…

Valuation:

Terms of the Transaction

Sandstorm has agreed to purchase 25% of the first 3,800,000 tons of metallurgical equivalent coal produced and 16% of the life of mine metallurgical equivalent coal produced thereafter from the Rosa and the Rex No. 1 Mine for an upfront payment of US$30 million plus ongoing per ton payments of US$75 for metallurgical coal. NovaDx has provided Sandstorm with a guarantee that Sandstorm will receive minimum cash flows of $5.0 million in 2012, $6.0 million in 2013, and $8.0 million in each of 2014 and 2015.

For our purposes here, lets ignore the potential measured and indicated reserves and just use the 39m Tons of proved and probable currently on the books. Let’s also be ridiculously conservative simply for conservatisms sake, and assume that only 55% of this number is recoverable, so the amount of total recoverable reserves at Rex is ~20m Tons. Now depending on how well you think management will execute, normalized production volumes should fall somewhere between the 500k ton “kitchen sink” estimate used to manage expectations and lets say 1m tons at full utilization upon maturity.

Either way you slice it then, were looking at a wonderfully long-lived asset. With conservative recovery estimates on 2P reserves of ~39m tons and a range on steady state production between 500k to 1m tons a year, the Rex No. 1 LOM is somewhere between 20 & 40 Years. So let’s split the difference and say the LOM is 30 years. So, our senior secured high margin annuity has a duration of ~3 DECADES.

If management reaches a steady state production level of 1m tons at some point within the next ~5 years (which to a generalist at least, seems like a reasonably plausible outcome), then at 1m tons per year in production Sandstorms 16% interest would equal ~160k tons per year. Assuming ~160k tons and a reasonable after-tax cash margin/ton of $115 (met coal price of $190/ton – $75/ton fixed cost), SND would earn ~$18.4m in a normal year. Not bad.

Again this is conservative because SND will receive a 25% interest of the first 3.8m tons produced or for about the first 6-7 years of the life of the assets and 16% thereafter. Just for fun, 25% of first 3.8m tons equals 950k tons to SND. So 950k in annualized production x $115 cash margin/ton = $109,250,000 in total undiscounted gross profit attributable to SND over the first 6.3 years of production (3.8m /600k in normalized production – 450k Rex, 150 Rosa). SND’s total current EV today is roughly ~100m.

What’s a reasonable multiple to pay for a growing, high margin ~30 year bond-like annuity with a normalized/inflation protected coupon of ~$18.4m and a “AAA” credit profile (capital at risk is fully covered and then some)?  What’s that worth when a return free 10yr treasury is ~2%? Let’s be borderline insane and say it’s only worth 12x. In that case, the Rex stream is worth ~$220m our over 2x the implied enterprise value of SND today.

The fact that Watson was able to purchase this wonderful asset for only $30m is yet another example of his demonstrated ability to literally crush the ball. The man sees his pitches clearly, and clearly knows when its time to really swing. And not that I’m counting my chickens before they hatch either, its just that under any reasonable future scenario this asset should make a lot of money for a very long time. That, and given the embedded value of the reserves, in place infrastructure, etc its almost inconceivable that they would permanently lose money here. Once again, the asymmetry here is stunning.

For more of the same Jedi Knight style value creation, take a look at the IRR’s on these streams and the embedded and highly visible, multi-decade runway of high return reinvestment opportunity that they provide.

Note: In thinking about the IRR I’ve decided to capitalize the cost of the asset and write it down over its life on a straight line basis (annual costs). I conservatively assume a ~20 year LOM. Feel free to front load the initial investment over 5 or 10 years instead of 20 if you wish, either way its still a phenomenally good use of capital.

Normalized Economics: The Rex No. 1 Mine

Annual Investment:              $10,625,000

Unit Cost Breakdown:

Annual cost/Ton                   $10/Ton

Cost/Ton                                  $75/Ton

Normalized Op Cost/Ton      $85

Normalized Production                125,000

Normalized Met Coal Price         $190

Normalized Op Cost/ton              $84

Steady State Free Cash Flow     $13,125,000

Normalized Economics: The Rosa Mine

Annual Investment:              $2,936,250

Unit Cost Breakdown:

Annual cost/Ton                  $13.3/Ton

Cost/Ton                               $65/Ton

Normalized Op Cost/Ton      $78.3

Normalized Production                37,500

Normalized Met Coal Price           $170

Normalized Op Cost/ton              $78

Steady State Free Cash Flow     $3,438,750

Rex No. 1: Base Case

Notes: FCF assumes SND caps out at 125M tons in annualized production at maturity. A multiple of 12x seems unjustifiably conservative given Rex’s recoverable reserve value of 20m+ tons of silicon based metallurgical coal. Remember SND pays no taxes and is debt free so gross profit pretty much approximates FCF.

Normalized Revenue                         $23,750,000

Normalized operating costs             $9,687,500

Steady State Free Cash Flow   $14,062,500

Implied Per Share value of SND’s interest at 12x SS FCF             $168,750,000

Implied Value Per Share                                                                                $0.53/share

Implied Per Share value of SND’s interest at 15x SS FCF              $210,937,500

Implied Value Per Share                                                                                 $0.66/share

Rex No. 1: Best Case

Notes: FCF assumes SND caps out at 250M tons in annualized production at maturity.

Normalized Revenue                          $47,500,000

Normalized operating costs            $19,375,000

Steady State Free Cash Flow     $28,125,000

Implied Per Share value of SND’s interest at 12x SS FCF              $337,500,000

Implied Value Per Share                                                                                 $1.06/share

Rosa Mine: Base Case

Notes: FCF assumes SND caps out at 37.5k tons in annualized production at maturity. A multiple of 5x seems unjustifiably low given management expectations of a fully developed Rosa LOM of 10-12 years.

Normalized Revenue                      $6,375,000

Normalized operating costs        $2,936,250

Steady State Free Cash Flow   $3,438,750

Implied Per Share value of SND’s interest at 5x SS FCF              $17,193,750

Implied Value Per Share                                                                                 $0.05/share

Royal Coal: Victory in Defeat

As an aside, let me publicly proclaim that Royal Coal be damned – it was a good decision and a bad outcome, it will by necessity happen from time to time, and shareholders should get their money back under a reorganization anyway. Eventually. That, and I couldn’t help but find it delightful to hear on last week’s inaugural conference call that Watson was able to emerge victorious even in in the jaws of defeat. Specifically, shareholders learned that by doing the deal, the company earned a tax shelter with an NPV worth more than the entire amount of the Royal Coal investment. Good form!! In all seriousness, that’s exactly the type of hidden revelation that warms a value investor’s heart. Makes you want to make a T-shirt with a picture of Watson with RULE #1 in bold above it doesn’t it not?

So to conclude…

Watson has made a stunningly asymmetric bet on high quality, silicon based metallurgical coal that should eventually pay off many multiples of his invested capital over time. This initial investment of $30m comes with a put option in the form of a 5yr guaranteed payback and a low-risk, highly visible runway of high return reinvestment opportunity that should last for many decades to come.

Initial Production come 2013 should approach an initial run-rate of 125m tons a year or ~ $14.3m in profit to SND’s bottom line (500m tons * .25 = 125m tons to SND or ~$14.3m in annualized gross profit assuming a 2013/14 price of $190 per ton. And as I’ve outlined above, this annual run-rate of ~$14.3m in gross profit could easily double as NovaDx’s management continues to tackle the abundance of low hanging fruit on its properties in the fullness of time.

Last but not least, the Rex No. 1 mine possesses the potential to be a low-cost mid tier silicon based coal producer for the next several decades and is hence a scarce, hugely valuable high quality coal asset given its low cost operations, consistent regional geology, long-term contracts and huge 2P reserve value, not to mention in place infrastructure and access to ports.

So while I put together an overview of the next significant stream that SND investors are currently getting for free, let me ask, what’s not to love here?

March 2012 Novadx Presentation (H/T to Joel Kitsul, NDX’s new IR!!)

The New World Economy and the Global Met Coal Market (H/T Alex)

July 2010 NovaDx Private Placement Presentation

Inaugural Conference Call

http://www.sandstormmetalsandenergy.com/i/media/March16-2012-MetalsEnergy.mp3

Ray Dalio on deleveraging

H/T to Plan Maestro