by Travis Johnson, Stock Gumshoe | June 19, 2015 5:01 am
Not really banks, but “sort of” banks, that’s what I’m going to write to you about today — and I’ve got a couple interesting ones that I own to profile for you today as they share the “Idea of the Month” spotlight.
Banks in general are in everyone’s good graces again — the stocks are pretty cheap, the widely-held perception is that a gradual rise in interest rates will bring about a new income boom for them again, and the “big” banking stocks have been rising. My favorite way to play that, if you’re interested, is still the TARP Warrants — those are not quite as dramatically exciting as they were a couple years ago when we first bought them, when they had 5+ years to go before expiration, but they’re still a great way to get leverage on big banks without really having to pay any premium for that leverage. Remember that leverage works both ways — you can in some ways get free options-like leverage with these for a long period of time, but you also do have the downside leverage risk… if the underlying stock drops by 30%, the warrant could lose 100% of its value.
The TARP Warrants I still own are on JP Morgan (JPW-WT is the Yahoo Finance symbol) and PNC Financial (PNC-WT), and PNC-WT would be my top pick for safety and high potential return still. I also have Boston Private Financial Holdings warrants (BPHFW), but that’s a private bank and asset management company, it’s not as cheap as the big banks, and it’s far riskier and quite illiquid — I’m more likely to sell BPFHW than to buy more at this point. And maybe the most interesting one that I don’t own is Bank of America (BAC-WTA), just because everyone still hates Bank of America and it has yet to really get out of its own way — I haven’t bitten on that, since the risk of the stock just stagnating even if the banking economy improves seems substantial to me, but I’ve seen more chatter about it recently.
I’ve written about most of this before, but here are the quick details on those biggies:
JPM-WT has a strike price of $42.42 (a few cents lower, actually, with dividend adjustments… adjusts for quarterly dividends over $0.38 per share) and an expiration date of October 28, 2018. JPM is a little over $68 as I type, so the warrant is worth at least $26 since you could exercise it now to own JPM at $68 and change. JPM-WT has traded almost exactly at exercise value of late, so provides free 3-year leverage — last I checked it was at $25.96.
PNC-WT has a strike price of $67.33, no dividend adjustment yet (dividend has to exceed $0.66 per share first, quarterly), and an expiration date of December 31, 2018. With PNC at $98, the value of the warrant should be right at about $31.50 — as I type, it’s trading below exercise value at about $30.50. If PNC rises by 20% over the next 3-1/2 years, which I think is a conservative expectation (not annualized, but 20% overall), then PNC-WT should rise about 65%.
BAC-WTA has a strike price of $13.30 (actually a few cents lower with dividend adjustments — the strike adjusts for dividends over one cent/quarter, and BAC for the past year has paid $0.05/quarter) and an expiration date of January 16, 2019. BAC is recently at about $17.30 so the warrants ought to be worth at least $4 — they’re trading at a little over $6, a reflection, I think, of the perception that BAC has more upside potential than the other big banks because it has remained so beaten down. Riskier than JPM and PNC, I think, but perhaps more explosive potential if they really get their act together (and interest rates help them out).
But that’s not really what I want to write to you about today — today I’m writing about some oddball Canadian “banks” in which I have very small positions (I’ve mentioned both in passing before), Grenville Strategic Royalty (GRC.V in Canada, GRVFF OTC in the US) and First Mining Finance (FF.V in Canada, FFMGF OTC in the US). Grenville is a small business lender that provides funding in exchange for top-line royalties on sales, First Mining Finance is a “mineral bank” that’s planning to buy up cheap mining properties while prices are low and be patient in finding partners to develop those properties once market conditions improve.
Both are tiny and young, with market caps under $100 million (though thankfully far larger than that tiny Otis Gold we talked about on Wednesday). Grenville pays a dividend, First Mining does not (and probably never will). Both are likely to raise capital by selling more shares. And both have potential to grow into something meaningful, I think, though they’ve got a ways to go to “grow into” their overhead costs. Let’s look at them in some more detail.
First I’ll cover the one I’ve owned longer, Grenville Strategic Royalty. This is one I nibbled on, wrote briefly about, and put on the “watchlist” back in March, and I’ve been following it more closely since then and looking through the books.
Here’s a partial excerpt of what I wrote in March:
Grenville is not a typical royalty company — they’re not in the commodities space at all, they are really trying to emulate Alaris (AD.TO, ALARF) in smaller or earlier-stage businesses (and the Business Development Companies, to a lesser degree), they provide capital to operating businesses in exchange for an ongoing gross sales royalty.
They have existed for about a year and a half, and have deployed about $25 million in capital to acquire royalty streams. Their return rate goal is 25%, and they’re hitting it so far… so they might fund a small business which has $10 million in annual sales with a $1 million deal for a 2.5% gross sales royalty. That would let them earn back the $1 million, if sales stay steady, in four years — it will take longer if revenue drops, and if the company grows and does very well it could pay back faster and continue generating large royalties for a long time.
It’s a fairly expensive financing option from my perspective, but you can see it working for some companies because it’s not debt so doesn’t come with those obligations… and it’s not controlling equity like a venture capital firm would demand, so they don’t get a board seat or operational oversight. And it’s appealing for Grenville because, like most royalties, it comes off the top — from revenues, not from profits. They’re aiming, it appears to me, at small companies that are local or specialized, growing fairly slowly in most cases, and probably aren’t ever going to be big enough or profitable enough to be public or attract venture funding on good terms… so private owners can raise some capital without borrowing from the bank, to take some money out of the business or to buy out a partner or to finance expansion, without losing any control. Lots of businesses might find that appealing.
Grenville has a pretty simple set of criteria they use for choosing business partners — they want businesses that have been operating for at least five years (at which point the failure rate falls considerably), they want to stay away from commodities, they’re staying with small and medium-sized businesses who have annual revenue up to about $100 million, they want management to have been at the company for a considerable time and to have personal capital invested in the company, and they want some kind of visibility into two years of revenues. Their companies generally have pretty high gross margins right now, above 30%, so those companies can clearly handle a small haircut off the top line — companies with razor-thin margins, like some retailers, probably wouldn’t be a good fit.
The beauty is that Grenville is working in a pool where they can reasonably expect a four-year payback of their investment — and the risk that goes with that beautifully quick return is that their investment is not necessarily secured by a valuable asset or franchise.
So far, they have invested now a total of about $35 million into 20 companies, and their goal is to hit 50 companies in their next stage of growth. They are currently generating that 25% internal rate of return that they aim for (which is good, since the economy is pretty strong — that may be tested more severely if the economy falters considerably), and the real risks to that return are weaker revenue growth at their partner companies. The investments so far are about half in the US and half in Canada, so there will also be some exposure to currency fluctuations no matter which side of the border you’re on. The royalty rates range from 1-4%, we’re told, but the average is over 3%.
The company depends on a few things — mostly on the continued viability of their royalty partners, but also on their ability to continue to get new businesses as customers/partners, and to do so on decent terms. The royalties they have on the books now will not disappear immediately, but if the companies are successful there are provisions for them to buy down the royalties if they wish (or to buy back the royalties completely, particularly if the company is bought or goes through a similar substantial transition), and in order to grow they’ll have to keep expanding their customer base.
So far that doesn’t appear to be a problem, though as a very small company it could become an issue at any time — finding new customers could get more expensive if they’re forced to go out and market themselves more aggressively to get qualified companies interested, or if a strong crop of competitors appears (there are, of course, competitors now — royalties got a big kick of attention a few years ago and there’s quite a bit of venture capital in the space, but I haven’t seen anyone with offerings as simple and clear as Grenville’s… nor are the competitors publicly traded). Grenville offer speed (providing funding in less than a month in many cases), continued control, some flexibility, and no restrictive covenants (like, your CEO has to sign over his house as collateral… or earnings have to remain in a certain range), so as long as they can maintain a good reputation and they continue to have happy customers, they should be able to grow reasonably quickly without onerous expense.
There has been one writedown of consequence, which is probably a good thing — it serves as a reminder that you don’t get 25% returns without risk, and hopefully it has refocused management on that risk. The writedown was quickly taken, it appears, when news came to light about one of their partner companies — and they wrote down the $1 million they had invested. That’s a nice side effect of the fact that they’re dealing with very small companies and the investments are generally quite small, that writeoff was only 3% of the value of the portfolio, roughly, and the company said that it was well within their expected return calculations to have occasional small writeoffs.
As I mentioned when I first mentioned my interest in (and purchase of) Grenville, they’re not necessarily cheap — you have to assign some meaningful value to their portfolio of royalties, and to their established business relationships and brand name, in order to make a purchase seem reasonable at these levels. The stock is up about 30% from where it was in early March when I wrote about and bought it, and I didn’t think it was cheap when I bought it. Part of that strength is from their dividend, which has had some time to settle in and become “expected” now, and from the attention that has come from their continued financings at decent terms as they’ve grown their equity base (they sold $12 million at 80 cents a share in April, after raising $11 million at 58 cents in February) — this is now a company just about touching C$100 million in market cap, more than that if you account for their $18 million or so in convertible debt (the conversion kicks in at 92 cents, so it will become a bit dilutive at some point).
So if you assume that convertible debt all converts and they have an equity base of about $115 million (these numbers are all Canadian), what do the actual financials look like?
Well, it gets a little crazy when looking at the last quarter, because one of their biggest income lines is from foreign exchange gains (since the US$ did very well against the Canadian dollar), but as I read it they are on a run rate of about $1.6 million in royalty payments per quarter and about $1 million in total “real” expenses (including salaries, overhead, professional fees, interest on the convertible debt), which means that their dividend is more than their earnings, but not dramatically more, and should be covered by cash flow. The dividend is five cents a share, payable in monthly installments of about four tenths of a cent per share, so the current yield is about 5.6%. The royalty income is steadily but not dramatically increasing, and should continue to grow — but the share count will continue to grow too, most likely, the challenge is that they’re right at the point where they’re starting to be able to afford the overhead they already have… so they need to make sure not to increase their overhead too much as their share count and revenue increase. The model works, it seems to me, but it works only if expenses are under control and if they choose solid companies to buy royalty streams from.
The 25% internal rate of return on capital is only for the capital that has already been invested, which is about $35 million at this point — so the returns to shareholders are lower than that, of course, because we’re currently paying almost three times that much for the company (though that includes $23 million in cash that they have available to make royalty investments), but that means the royalty income should be surpassing $2 million a quarter pretty soon, and hitting $3 million a quarter if they invest all that cash effectively.
So there’s pretty substantial cash flow growth potential if they keep up the good work, but the current valuation gets a little worrisome. If you back out the cash and don’t include the convertible debt outstanding you’re still paying twice what the company paid for their royalties, which does loosely correlate to their valuation at about 2X book value. I’d be willing to make an initial investment at this price, but I remain a little bit surprised that the shares have shot up so quickly this year — there’s certainly some growth assumption built in, or some recognition of the very scalable nature of their business model. As they grow, they should have much of their royalty growth hit the bottom line — and if they can grow mostly with equity, and not have many writeoffs for bad deals, they’re effectively paying 5% (the dividend) for money that they can invest at a 25% annual rate of return. Obviously there’s risk — you don’t get a 25% return without risk — but I like this better than the BDC model for small companies and I think there is a subset of small and medium-sized businesses where a royalty investment is far more appealing even though it ends up being relatively high in cost.
The valuation above 90 cents a share worries me a little bit, I’d prefer to build a position 10-20% below that number, but — as we’ve seen with Input Capital, which has a similar model when it comes to cash flow — royalty companies can be valued at a stiff premium to the price they paid for their royalties if they have a defensible niche or, as is the case with Grenville, if they pay a dividend that is substantial enough to provide some support for the shares. There is still upside potential from here if they can continue rolling new equity into new royalty agreements, and though it’s fairly slow going they seem to be on pace to do just that.
Their investor presentation from last month is here, their last quarterly release is here. I can see a rationale for buying this young and growing company at 2X book value, but recognize that you’re paying for expected growth as they increase the size of their portfolio — it should work, even as they raise extra equity to fund that portfolio, simply because the return on capital is so high, but there’s more risk buying it here than there would be if you paid a smaller premium to the value of the portfolio. I’d nibble here, and hope for a writedown or a piece of bad news to bring the shares down to the 70 cent range before making a larger commitment to the stock. I own the shares, and won’t trade them for at least three days (probably a lot longer, I anticipate — this is one I’d like to hold a small position in, let it compound, and watch it for a while to see how they manage their royalty quality and expenses as they grow the portfolio).
And my other odd little bank, the one that I first mentioned to you last week: First Mining Finance (FF.V in Canada, FFMGF on the pink sheets).
First Mining Finance is, to be honest, largely a story stock. It’s a bet on a management team, and on the boom and bust cycle of mining stocks. They call themselves a “Mineral Bank” — and they sort of are, but it’s more like they’re aspiring to be cheap hoarders, buying up little unwanted mines when things are ugly and waiting to be sweet-talked into selling them when there’s a bull market in mining again. They’re not the only ones doing this — as you can tell from the endless prattle of any mining newsletter pundit, this is the time to buy buy buy! When there’s blood in the streets! And great properties are on sale for pennies on the dollar!
So to a large degree, to expect big returns over the long term from First Mining Finance you have to believe in the people in charge, you have to expect mining to turn around someday, and you probably have to be patient as you wait that out — because the company’s not likely to spend a lot of money trying to add value to their assets, explore, drill, or anything else that gets attention. They’re going to wait until someone who does want to invest in drilling and building a mine comes to offer them a deal… and that almost by definition won’t be happening until the commodities markets turn, because that’s when the stupid money will come flowing into junior miners, and those junior miners will be knocking on the door at First Mining looking to buy attractive mining properties to justify their existence and spend the money that people keep throwing at them. So that’s the backdrop story — if you don’t see that happening within the next several years, you won’t like First Mining Finance.
So what is this company? First Mining Finance is the latest creation of Keith Neumeyer, who founded First Majestic Silver (and helped found First Quantum Minerals in uranium) — both of those were (Quantum still is) multi-billion dollar companies. He is still Chairman and CEO of First Majestic Silver, one of the largest pure play silver miners, and he essentially seeded First Mining Finance with its first portfolio of projects by spinning off the early stage developmental projects from First Majestic Silver into this new company in exchange for about a 30% equity stake. Those 18 projects together come in with a capitalized investment of about $6 million for past exploration (that’s the value at which they’re now carrying those projects on the books, most of the projects are in Mexico).
They did a fairly complicated reverse take over to get a public listing, with financing from Neumeyer and some other early investors, and then did a private placement to raise about $4 million at C$0.40 per share (plus warrants) in conjunction with the public listing. With that, and their earlier financing from seed investors now freed up, they have a little more than C$6 million in cash — and they also just did their first big transaction as a public company, acquiring Coastal Gold and its high-grade past-producing Hope Brook gold mine in Newfoundland for about $11 million in First Mining Finance shares. That was a huge premium to where Coastal Gold was trading before, but they had to bid up to get it away from Sulliden Mining Capital, a tiny ($8 million market cap) mining-focused venture capital firm who tried to buy Coastal first. So Hope Brook immediately becomes their most valuable property, and the most advanced. The focus is on gold and silver in the portfolio now, though there’s some copper and other minerals as well.
Which means… we’re left with Hope Brook, worth something between $3 million and $11 million if we believe the markets, and the other properties that they’re carrying on the books at $6 million. Obviously, the hope is that in several years these will be partnered, will get developed, and will generate either royalties or joint venture revenue and will be far more valuable… but the reasonable book value now is in the neighborhood of $10-15 million. Add in the cash, and you get to something right around $20 million if you’re being reasonable and doing a bit of rounding (these numbers are all estimates, really). Once the Coastal Gold deal is done, First Mining Finance will have almost exactly 100 million shares outstanding, so they have a market cap now of about C$35 million (using the 35 cents I saw them traded at recently — that might have changed by the time you read this). So that’s about 1.75X book value, if you want to use that valuation.
Which is almost exactly the price/book valuation of Altius Minerals (ALS.TO, ATUSF), my largest commodity-related position. That’s a complete coincidence, but it gives some frame of reference — Altius has a similar business model, though they’re 15 years ahead of First Mining and they’re not particularly comparable at this time… but both of these companies are dependent on the fact that their book value dramatically understates the real value of their assets because the market is not currently ascribing much value to their assets. Certainly, in a future world where silver and gold are again soaring (if such a world comes to pass), investors will be willing to value prospective mines, with drill results and (in some cases) resources or reserves already booked, at far more than the money that was spent exploring those properties.
So this provides some reasonable comfort to me, a look at the actual finances — but really, what the bet is here with First Mining Finance is that they will continue to use their stock, which comes with a big of glow from the solid reputation of Keith Neumeyer, to acquire beaten-down mines that have sucked up lots of exploration spending and are now starved for capital to advance their projects… but which are undervalued if you assume that the commodity cycle will again turn someday. First Mining isn’t going to advance the projects, either, or at least that’s not the plan (mining is best done using other peoples’ money, not your own), but they do have plenty of cash on hand to continue to pay their geologists and keep the lights on and evaluate mines as they continue to buy and hold potentially valuable mineral properties until such a day that that value can be realized. Neumeyer stated in the initial materials and presentations for the company that they already have their eye on 60+ attractive projects who have distressed owners, and I expect they’ll continue to use both their stock and a little bit of their cash to keep acquiring such projects.
It’s definitely speculative, it’s a long-term investment that assumes commodities will regain their luster eventually, and it requires patience — but I think $35-40 million is a reasonable price to pay to get on board with this management team, with their expertise at building companies in the past, and see if they can create some moon-shot returns if the gold and silver bull comes back. It’s a very small position for me, I wouldn’t pay more than 40 cents (that’s about US$0.33), and I wouldn’t do it at all if you’d be worried about a 50% loss — this is very much a risky, long-term speculation based on the fact that I think a guy who has built great mining companies can also build a great “Mineral Bank” company out of the ashes of the mining crash.
That’s all I’ve got for you today — a very speculative mineral bank, and a much less speculative (but still risky) dividend-paying royalty bank. Both are interesting at today’s prices, neither is trading at a clear or absurd discount to their current value — and I know of no immediate likelihood of catalysts that could force these shares higher, though the possibility of that is much more present in First Mining (given the chance that they could make a deal to sell or acquire a property at any time) so it’s probably wise, if they appeal to you, to nibble at such shares when they’re less popular. I own them both, and will not trade them for at least three days — I intend to let these small investments ride, with perhaps substantial volatility, for the foreseeable future.
And, of course, if those “silly” little banks don’t appeal I do still very much like PNC Financial’s warrants as my favorite play on big banks if you feel, as the market pundits seem to, that banks will start to make more money from boring old banking in the years to come as their interest rate spreads improve with rising rates (or if you want a bit more stolid a pick, JPM warrants… or a more speculative one, Bank of America A warrants).
I’ll be on vacation with my family over the next two weeks, so there will be sporadic new articles as things come up, and I’ve got a couple guest authors lined up to write some pieces, but you probably won’t see any long Friday File pieces until after the Fourth of July
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