ATVI merger failing? Maybe not so bad... and picking up an odd lot

Provided to subscribers June 11th.

Here is the latest from Canadian Value Investors!

• An odd lot trade - DND

• What is an odd lot trade?

• ATVI merger failing? Maybe not so bad…

DND Odd Lot trade

Thank you for subscribing! Here’s $150 - Dye & Durham TSX:DND Odd Lot Trade - $15.36 vs $17-$20, return of ~$150 or 10% for a few minutes of work.

FYI this gets complex for non-Canadian investors and there is always uncertainty of completion; do your own due diligence (as always).

DND is doing a share repurchase and they have an odd lot provision (if you’re not familiar see next). Details below from their proxy; you have until June 16th to purchase, settle, and submit your shares and make sure your trade has settled before then.

The Offer will commence on the date set forth above and expires at 5:00 p.m. (Eastern time) on June 16, 2023 or at such later time and date to which the Offer may be extended by Dye & Durham (the “Expiration Date”). Per their disclosures:

Holders of Common Shares (“Shareholders”) who wish to accept the Offer may do so in one of two ways: (a) by making an auction tender (“Auction Tender”) pursuant to which they agree to sell to the Company at a specified price per Common Share (not less than $17.00 and not more than $20.00 and in increments of $0.10 within that range) a specified number of Common Shares owned by them; or (b) by making a purchase price tender in which the tendering Shareholders do not specify a price per Common Share, but rather agree to have a specified number of Common Shares purchased at the Purchase Price (as defined below), to be determined pursuant to the Offer (“Purchase Price Tender”), understanding that if they make a Purchase Price Tender, for the purpose of determining the Purchase Price, such Common Shares will be deemed to have been tendered at the minimum price of $17.00 per Common Share.

…

Shareholders validly depositing Common Shares pursuant to Auction Tenders at $17.00 per Common Share (the minimum purchase price under the Offer) and Shareholders validly depositing Common Shares pursuant to Purchase Price Tenders can reasonably expect to have all or a portion of such Common Shares purchased at the Purchase Price if any Common Shares are purchased under the Offer (subject to provisions relating to proration and the preferential acceptance of Odd Lot Holders described below).

…

For the purposes of the foregoing, an odd lot deposit is a deposit by a Shareholder owning in the aggregate fewer than 100 Common Shares as of the close of business on the Expiration Date

WHAT DOES A SHAREHOLDER DO IF THAT SHAREHOLDER OWNS AN “ODD LOT” OF COMMON SHARES?

If a Shareholder owns in the aggregate fewer than 100 Common Shares as of the close of business on the Expiration Date and that Shareholder validly deposits all such Common Shares pursuant to an Auction Tender at a price equal to or less than the Purchase Price or pursuant to a Purchase Price Tender, the Company will purchase all of those Common Shares without proration (but otherwise subject to the terms and conditions of the Offer) if the Company purchases any Common Shares pursuant to the Offer. This proration preference is not available to holders of 100 or more Common Shares even if holders have separate share certificates, ownership statements or DRS positions for fewer than 100 Common Shares or hold fewer than 100 Shares in different accounts. Odd Lot Holders making an Auction Tender or a Purchase Price Tender will be required to tender all Common Shares owned by the Shareholder. Partial tenders will not be accepted from Odd Lot Holders.

What is an Odd Lot Trade?

When companies repurchase shares they use various repurchase strategies. They set a target dollar amount of shares to repurchase. The strategies companies use for repurchasing is for another day (and probably another blog), but the important thing for value investors is that they sometimes offer a small but extremely high return on capital at very low risk.

Companies sometimes incorporate odd lot provisions in their repurchases, which means (typically) that if an investor has 99 shares or less (i.e. not holding a lot of shares) they will get repurchased first. Companies do this for a few reasons, primarily to simplify shareholder communication and stockholder structure.

How does this benefit you? Well, if a firm repurchase comes up and the stock is trading below the repurchase price or range, you can buy 99 shares and know you will be bought out by the company first so long as the repurchase goes through.

To submit your shares you just have to reach out to your broker. Sophisticated brokers that are used to this kind of thing (hi Interactive Brokers) let you do this online easily. Others might require you to email them and (George Carlin voice) the worst… make you call!

Here’s how it works with Interactive Brokers – After your trade settles (or if you already owned the company) you can head to your notifications and let them know what you want to do. As shown below, you indicate that you want to tender your full position. If you use Qtrade this can be done with a secure email through their online account. If you use a brokerage account at a chartered Canadian bank, you should switch to something better immediately.

It’s not big money, but we still take the time to pick up $100 bills we see on the sidewalk.

ATVI merger failing? Maybe not so bad

Disclosure: We still own ATVI

We have been following (and posting about) Microsoft’s acquisition of Activision-Blizzard for the past year. Unbeknownst to us until 13-F day, we bought ATVI alongside Warren Buffet last year, only to have the odds of the trade blow out the wrong way near the end of this April. But… maybe the merger failing would not be so terrible for a cash flow positive company with a couple great franchises. Especially if you have $12-14 billion saved up by the time it fails. We argue that there might be a golden egg regardless of what happens. “Heads you win, tails you don’t lose (much?)”

Merger Update

As noted in several posts (see archives), the Microsoft-ATVI merger has been dealing with antitrust reviews around the world. Our main concern was the U.S. Federal Trade Commission (FTC) and Linda over there blazing a trail https://www.bloomberg.com/news/articles/2023-06-06/lina-khan-is-upending-wall-street-s-merger-arbitrage-playbook , but out of left field came the CMA. Per their Q1/23 release:

“On April 26, 2023, the United Kingdom Competition and Markets Authority ("CMA") announced a decision to block the merger, stating that competition concerns arose in relation to cloud gaming and that Microsoft’s remedies addressing any concerns in cloud gaming were not sufficient. Activision Blizzard considers that the CMA’s decision is disproportionate, irrational and inconsistent with the evidence. Microsoft has announced its decision to appeal the CMA’s ruling, and Activision Blizzard intends to fully support Microsoft’s efforts on this appeal. Activision Blizzard continues to believe that the deal is pro-competitive, will bring Activision Blizzard content to more gamers, and will result in substantial benefits to consumers and developers in the UK and globally. The parties continue to fully engage with other regulators reviewing the transaction to obtain any required regulatory approvals.”

How often have companies been able to successfully challenge the CMA? “Essentially, there has never been a successful appeal in the UK on an antitrust decision,” said Aaron Glick, a merger arbitrage strategist at TD Cowen. “There does not appear to be a path forward for Microsoft.” https://www.bloomberg.com/news/articles/2023-04-26/microsoft-s-69-billion-activision-deal-blocked-by-uk-watchdog

Oof.

The merger is not off, but the odds have changed. But, this brings two interesting things into play if it fails: 1) Underlying business performance of the company since the announcement (how much is it worth), and 2) the Microsoft break fee.

First, let’s deal with the easier question. If the merger fails due to a regulatory hiccup, The Termination Fee Microsoft would owe to Activision is straightforward and quite material. Microsoft’s deal team and lawyers seemed confident in anti-trust rulings going their way and did not give themselves an out we can find. Per the deal disclosures:

Reverse Termination Fee If the merger agreement is terminated in specified circumstances, Microsoft has agreed to pay Activision Blizzard a reverse termination fee of (i) $2,000,000,000, if the termination notice is provided prior to January 18, 2023, (ii) $2,500,000,000, if the termination notice is provided after January 18, 2023 and prior to April 18, 2023 or (iii) $3,000,000,000, if the termination notice is provided after April 18, 2023. [CVI editor: the merger deal being $68.7 billion]

Activision Blizzard will be entitled to receive the reverse termination fee from Microsoft if the merger agreement is terminated: by either Microsoft or Activision Blizzard due to (1) a permanent injunction or other judgment or order arising from antitrust laws having been issued by a court or other legal or regulatory restraint or prohibition arising from antitrust laws preventing the consummation of the merger being in effect, or any action having been taken by a governmental authority arising from antitrust laws that, in each case, prohibits, makes illegal…

The Board of ATVI also stopped allocating surplus capital as their hands have understandably been tied by the merger agreement. Cash and short-term investments at the end of the first quarter stood at $12.6 billion, and Activision Blizzard ended the quarter with a net cash position of approximately $8.9 billion. This, plus expected free cash flow throughout the year results in about $12-14 billion of surplus cash by the end of the year (our timeline for final failure and assuming they keep $3-4 billion back) to use for repurchases (more likely) or dividends (less). This cash is only available to shareholders if the merger fails. With a market cap of ~$60 billion, that’s material.

How’s the business?

At the same time, they had a blow out quarter and the latest flagship game (the sequel to one of our childhood favorites) is selling like gangbusters.

Diablo® IV Launches, Immediately Sets New Record as Blizzard Entertainment’s Fastest-Selling Game of All Time

From: Business Wire
Jun-06-2023 9:06 AM

In just four days of early access, players have already enjoyed the latest installment of the iconic game for over 93 million hours, or over 10,000 years

IRVINE, Calif.--(BUSINESS WIRE)--
Diablo® IV, the highly anticipated new installment of the iconic Diablo series, is now live. Already, it is Blizzard Entertainment’s fastest-selling game of all time, with Blizzard’s highest pre-launch unit sales ever on both console and PC*. In the four days since early access started on June 1, Diablo IV has been played for 93 million hours, or over 10,000 years --- the equivalent playing 24 hours a day since the beginning of human civilization.

View the full release here: https://www.businesswire.com/news/home/20230606005812/en/

The Company has a few key franchises broken up between Activision, Blizzard, and King. We find it pretty amazing how resilient these franchises are. They can get tired and be broken; just look at what EA has done with numerous franchises like Sim City.

Key figures and charts below. Various reports we have read (before Diablo launching) put free cash flow in the range of $3-4 billion annually over the next few years. It currently trades at ~$80 or a market cap of about $63 billion. Netting out the surplus cash gets you a mid to high teens P/E multiple.

We want to point out that the merger is not quite dead. It is still quite possible (experts betting a bit less than 50/50 it seems based on recent reports we have read) that you get bought out at $95 sometime over the next year or so. Heads you win, tails you might not lose?

Clarke Inc. Special Situation(s)

Here is the latest from Canadian Value Investors!

• Clarke Inc. TSX:CKI Special Situation(s)

• Astrotech Corporation NSADAQCM:ASTC Special Situation – Shotgun acquisition

Clarke Inc. TSX:CKI Special Situation(s) – Sailing on the go-private ferry

Disclosure: We are long this stock and their debentures.

Clarke Inc. TSX: CKI is a neat collection of businesses and assets. It’s also probably being taken private shortly and has a special situation trade for you in the meantime. What’s the deal?

• It is trading at below its stated book value (which seems reasonable and likely has suppressed value).

• They are several years into a business simplification. They have sold off/dividended-out various public holdings (TerraVest – their case study at end – and Trican; both interesting investments) and are now focusing on their three business units.

• They have been consistently repurchasing shares for the last three years (15% cumulatively) and just renewed their NCIB. Now that they have cleared up the convertible debentures (see next), it is likely that they are going to be taken private soon.

• We looked at Clarke back in 2021. Unfortunately, we did not buy, and it went straight up ~100% since. At the time their operations were messier and the majority of their business at the time (hotels and a ferry) were severely impacted by COVID.

• They key 75% shareholder, G2S2 (run by Clarke’s Chairman) just put in the funds to repurchase the debentures. This is his party – “On June 30, 2020, Michael Rapps, former President and Chief Executive Officer of the Company, resigned and George Armoyan, Clarke’s Chairman, was appointed President and Chief Executive Officer.”

• The only other large shareholder is 13% owner Letko Brosseau & Associates Inc. This might provide some comfort for small shareholders getting a fair deal (unless they also continue holding with G2S2 in a go-private transaction).

First - The short-term trade: Clarke Inc. announced that they are repurchasing all of their convertible debentures at the end of July. They are listed on the TSX under CKI.DB. If you can get them for ~$1,000 or less your return is just over 1% in a month or ~15% IRR.

On June 28th, Clarke announced repurchase of all of their convertibles, which were at a generous rate of 5.5%, (i.e. they really wanted to clean up the capital structure). As a bit of background, they assumed these when they acquired their hotel business Holloway. We think that this is an indication that they are going to be taken private shortly; the convertibles are being paid for with a credit facility from their main 75% shareholder, G2S2 Capital, and the company’s chairman also runs G2S2.

Halifax, NS (June 28, 2023) – Clarke Inc. (the "Company" or "Clarke") (TSX:CKI) announced today that it has delivered a notice to Computershare Trust Company of Canada ("Computershare"), as debenture trustee under the trust indenture between the Company and Computershare dated September 30, 2019, as supplemented by the first supplemental indenture dated September 30, 2021 (together, the "Indenture"). Such notice of redemption provides that the Company will redeem the entire aggregate principal amount of $35,000,000 of its outstanding 5.50% Series B Convertible Unsecured Subordinated Debentures due January 1, 2028, which are listed for trading on the Toronto Stock Exchange under the symbol CKI.DB (the "Debentures") in accordance with the terms of the Debentures.

The Debentures will be redeemed on July 28, 2023 (the "Redemption Date") for an aggregate redemption amount of $1,013.41 for each $1,000.00 principal amount of Debentures, being equal to the aggregate of (i) $1,000.00 principal amount of Debentures, plus (ii) all accrued and unpaid interest thereon to, but excluding, the Redemption Date (the "Redemption Price").

In connection with redemption of the Debentures, the Company has entered into a credit facility (the "Credit Facility") with the Company's controlling shareholder, G2S2 Capital Inc. ("G2S2"). The Credit Facility bears interest at 6.00% and is interest payments only until January 1, 2028, whereby afterwards the Credit Facility will continue as a revolving line of credit on demand. The interest-only period aligns with the current maturity date of the Debentures, ensuring that the Company will maintain the liquidity requirements that the Debentures provided. 

Clarke Overview

The Company consists of three business units: 1) A ferry monopoly on the St. Lawrence River operating since 1973 https://traverserdl.com/, 2) a portfolio of hotels performing well, and 3) creative real estate projects.  

The ferry business is small and performance is opaque as they group it with other investments. However, after parsing through their financials, we estimate revenues and cash flow are $7-8MM and $1-2MM respectively.

The hotel division consists of 17 hotels under primarily Super 8 branding, but also Holiday Inn / Quality Inn / DoubleTree / Travelodge (detailed list is in the AIF). Four are in Grand Prairie, one landmark hotel in Whitehorse, and the rest in Alberta, B.C. and Ontario. COVID was tough, but – along with hospitality in general - the hotels are on the rebound. They are also doing renovations (Sternwheeler Hotel & Conference Centre in Whitehorse) and acquiring selectively. E.g. in 2022 they acquired the Stanford Inn & Suites in Grand Prairie for $11.6MM, at 206 rooms they paid ~$56,000 per door.

2019 background – “Holloway owns and operates hotels across Canada. In the first quarter of 2019, we began to consolidate Holloway’s results into our own results after acquiring control by obtaining 51% of Holloway’s outstanding shares. We acquired the remaining outstanding shares of Holloway on September 30, 2019 to increase our ownership to 100%.” The timing was terrible – right before COVID – but that was not foreseeable.

They have also wound down their management of third-party hotels to simplify the business (we agree).

The Company’s investment properties are interesting. Some are special situations (Houston) while others are taking advantage of existing assets (Carlin repurposing hotel site). The main developments are:

Carling – “Redevelopment of our excess land on Carling Avenue in Ottawa, ON (the “Carling Avenue Development”). While the first phase of construction is underway, pre-construction activities are also ongoing for its second phase. The two phases will consist of a multi-building residential apartment complex including ground-floor retail space. Phase one of the Carling Avenue Development consists of two residential towers with 404 rental units. While construction financing was secured in the fourth quarter of 2022, the project has been self-financed to date.” It’s a big project; $85MM credit facility was put in place https://canada.constructconnect.com/dcn/news/projects/2022/11/clarke-obtains-financing-for-ottawa-complex https://renx.ca/holloway-lodging-build-residential-towers-ottawa

Atwater Montreal – “The Company is a one-third partner in a real estate development project in downtown Montreal that is currently under construction.  The building is located at 1111 Atwater Avenue (the “1111 Atwater Development”), the former site of the Montreal Children’s Hospital. The development involves a 38-storey building including seniors’ housing, rental units and luxury condominiums, with extensive amenities for residents.” This is a bit of an odd one; in Q4 they said they exercised their right to exit (to receive costs plus 6% interest) but Q1 they indicated they are in negotiations to waive this right (“amendment would include the rescindment and forfeiture of the Company’s right to exit the COA and certain changes to the timing and order of the distributions of the Development’s ultimate cashflows”). https://goo.gl/maps/925jZFkUGwXV4LC98

Three vacant office buildings in Houston, TX totaling approximately 435,000sf “acquired far below [replacement cost]”. How did they get them? “On January 30, 2019, the Company purchased a non-performing US dollar loan receivable, secured by an office building, for US$4,800.  On March 5, 2019, the Company foreclosed on the office building.  On May 24, 2019, the Company purchased two office buildings in Houston, TX, for US$8,310”.

First is their book value calculation and then ours. Ours is pretty similar (e.g. the ferry business adjustment as it practically no book value but has intrinsic value obviously), though with the significant development and construction ongoing the number is a bit of a moving target. The implied revenue and EBITDA/CF multiple of the hotel business is a bit high if you compare to cost, but the underlying business continues to improve. Secondly, a significant part of their book value is tied to their construction projects and they are spending a lot to develop them. All reports here - https://www.clarkeinc.com/financial-information

Overall, their track record is quite good and their development projects are the kinds of things we wish we could do ourselves. We expect they will be accretive. The key question is will they play games with the timing of going private to try and get a lower price than today. The issue with these situations is you are at the whim of the key owners. Why would the go private price have to relate at all with the private company/true intrinsic value? It does not. However, in this case all the business units have tail winds, not headwinds, and so there is incentive to do it soon and no obvious triggers to cause a significant short-term price decline to take advantage of. Their automatic repurchase plan is an indication of this. And secondly, the public wedge is just so small now. For us, this is worth a small bet.

The spread between the share price and book value has compressed since we last looked, but their projects arguably have suppressed value or at least option value. And here are the repurchases. Also, the Chairman and CEO does not take a salary/options, but does have a very good pension… We have seen much worse.

 Automatic repurchase plan:

HALIFAX, NS, June 28, 2023 /CNW/ - Clarke Inc. ("Clarke" or the "Company") (TSX: CKI) (TSX: CKI.DB) announced today that it has filed a notice with the Toronto Stock Exchange and received its approval to purchase, through the facilities of the Toronto Stock Exchange or any Canadian alternative trading system, up to 699,232 common shares, representing 5% of the total 13,984,644 issued and outstanding common shares as of June 21, 2023 (the "Share Issuer Bid"). From December 1, 2022 to May 31, 2023 the average daily trading volume ("ADTV") of Clarke common shares was 3,278 common shares. Under TSX Rules, the Company is entitled to purchase up to 25% of the ADTV of the respective class of shares which is 819 common shares. Accordingly, under TSX rules and policies, the Company is entitled on any trading day to purchase up to 1,000 common shares. Any common shares purchased by Clarke pursuant to the Share Issuer Bid will be cancelled.

In connection with the program, the Company has established an automatic securities purchase plan (the "Plan") for the Share Issuer Bid. The Plan was established to provide standard instructions regarding how Clarke shares are to be repurchased under the Share Issuer Bid. Accordingly, Clarke may repurchase its shares under the Plan on any trading day during the Share Issuer Bid including during self-imposed trading blackout periods. The Plan will commence immediately and terminate with the Share Issuer Bid. The Company may otherwise vary, suspend or terminate the Plan only if it does not have material non-public information and the decision to vary, suspend or terminate the Plan is not taken during a self-imposed trading blackout period. The Plan constitutes an "automatic plan" for purposes of applicable Canadian securities legislation and has been pre-cleared by the Toronto Stock Exchange.

Purchases under the Plan may commence on July 4, 2023 and will terminate on July 3, 2024.

Astrotech Corporation NSADAQCM:ASTC Special Situation – Shotgun acquisition

Disclosure: We have a small position.

What do you do with a weird cash burning mass spectronomy company? Buy it of course. At least that’s what BML is trying to do. As of Q1 the company has ~$42MM of net cash and no debt vs its market cap of $23MM, i.e. a true net-net. However, they are burning cash, $7-8MM a year. Bizarrely, the Company recently announced a plan to raise equity, which did not sit well with their largest shareholder BML (13%), which is a value-oriented fund and they sent a non-binding offer (provided below). We have also included their portfolio below (seems like a good hunting ground!).

Per the Company’s acknowledgment, “The non-binding proposal is not subject to a financing condition but is subject to limited confirmatory due diligence and is based on the Company having at least $35 million of cash and cash equivalents as of the potential closing date of the proposed acquisition, net of any tail and closing costs, and not having issued any shares pursuant to its at-the-market offering agreement dated June 16, 2023 (the “ATM Agreement”). Effective June 27, 2023, the Company terminated the ATM Agreement in accordance with its terms.” The offer is ~$29MM for the Company and BML has cash on hand per their last 13-F to complete the acquisition.

BML bio per one of their analysts - BML Investment Partners is a concentrated value-oriented fund that invests primarily in domestic equity securities. The fund has no style or market capitalization mandate, but has focused mostly on small caps throughout its history. Based in the Midwest, BML has been exclusively managed since its November 2004 inception by Braden M. Leonard, its Founding Partner and second-largest investor. It generally purchases out-of-favor companies that fund management believes enjoy substantial return potential over a 2- to 3-year period. The fund employs a bottoms-up approach, eschews leverage, and adheres to a long bias the vast majority of the time.

Here is their letter. The conundrum is the offer had a very short life – it was provided June 26th and expires today. BML is a bit stuck; daily volume of ~10,000 means that cannot get out easily, meaning the offer likely has to be extended/adjusted or actually be accepted by the Board after market today. It might also start a process and attract competing bids (we view as unlikely).

Key risk: Entrenched management and Board who want their paycheques. High risk.

As always, do your own due diligence.

Graftech (NYSE:EAF) – Scuttlebutt, and tail risks, and value traps, oh my

Provided to subscribers May 28th.

A few years ago, we wrote up an article about Graftech International, the spin-off “niche business that the market forgot”. It was (and possibly is) an interesting business trading at cheap multiples, but we ultimately did not hold it for long and this turned out to be the right decision. Subsequent to our investment, they had a major regulatory hiccup at their key facility in Mexico (temporarily shut down completely; #awkward). Was this foreseeable? Maybe this is this a good business after all, and it is time to buy? We find post-mortems extremely valuable. Secondly, this is a good example of using scuttlebutt in a modern world. And finally, we still might take action on this depending on how their issues get resolved…

• What is Graftech? Brookfield’s turnaround pitch.

• What did we decide?

• Chapter 2: The strike scuttlebutt - Scuttlebutt in practice in a modern world

• Chapter 3: The long tail (risk)

Graftech and Graphite Electrodes 101

“So what would you say you do here?”

• Graftech describes itself as “a leading manufacturer of high-quality graphite electrode products essential to the production of electric arc furnace (or EAF) steel and other ferrous and non-ferrous metals.”

• The gist – Produce niche product graphite electrodes, which are essential to make EAF steel.

• They are one of the few if only vertically integrated manufacturers that also makes the main input to graphite electrodes, petroleum needle coke.

• It was a Brookfield Asset Management baby taken private, turned around, and then taken public 2018.

• It was trading at 4-5x free cash flow when we found it in 2019.

What are graphite electrodes?

Petroleum needle coke is a high-quality form of coke derived from oil refinery byproducts.

It is called "needle coke" because of its long, needle-like structure, which is essential for producing high-quality graphite electrodes [that have] a unique combination of high thermal conductivity, low coefficient of thermal expansion, and high mechanical strength.

Graphite electrodes are typically made from high-purity graphite and are used as conductive elements in EAFs to generate high temperatures required for melting scrap metal and other raw materials. These electrodes are highly resistant to heat and can withstand the extreme conditions of the EAF, which can reach temperatures of up to 3,000°C.

How graphite electrodes fit in

The table below summarizes the process well. Effectively, electrodes are a small but absolutely essential part of EAF steelmaking. Quality is also paramount and they are relatively hard to manufacturer (at least the highest grades are); if they fail/are low quality/fail prematurely, this can cause expensive operational problems and downtime. They argued that this made for sticky customers who are willing to pay for quality, so long as you are actually high quality and reliable…

Brookfield’s turnaround pitch

Brookfield acquired Graftech for $1.25 billion and put it through their turnaround process.

”We have achieved annual fixed manufacturing cost improvements and capital expenditure reductions of approximately $190 million since 2012, while also improving the productivity of our plant network We have strategically shifted production from our lowest to our highest production capacity facilities to increase fixed cost absorption.”

Graftech “netback”

We have covered oil and gas quite a bit, and the term "netback" refers to the profitability of a barrel of oil or natural gas after deducting all associated cash operating costs, such as transportation, processing, and marketing expenses (not accounting for the cost to find a barrel; a discussion for another day). For Graftech, you can do a similar analysis. Here is what it looked like when we did our first check.

This looks great when compared to their long-term contracted rates, but not so great when compared to historical rates or spot rates.  “Where were those new contract renewals” we wondered? Maybe they will come.

Measuring price and success since 2015 acquisition by Brookfield

(with the benefit of hindsight and more data than our original purchase)

What did we decide? It was time to buy!

We bought in December 2019 because:

1. Lollapalooza - Essential product, difficult to produce, small part of cost of overall production, concentrated producers, high risk from bad product.

2. Low multiples and delevering plans in place supported by long-term fixed price contracts.

3. Targeting significant cash flow to shareholders including repurchases (“50-60%”).

But we ultimately sold out in November 2020 because:

1. The Company unable to sign new contracts, high price old ones running off/getting renegotiated. COVID was not helping this and we worried they might have to even renegotiate existing contracts, never mind not be able to find new ones.

2. Spot prices were ~$5,500MT with further downward pressure.

3. Even with OK pricing the Company still has high leverage at reasonable prices of $7-8,500 w/ high P/CF multiple of $1.75B to ~$200MM =9X @ $7,000 MT

4. Brookfield was still selling, causing sell down pressure (and the nagging feeling that you are buying from a smart counterparty that has much more knowledge than you).

Chapter 2: The strike scuttlebutt - Un problema grande

Berkshire Hathaway AGM this weekend. What are "owner earnings" anyway?

Provided to subscribers May 4, 2023.

Here is the latest from Canadian Value Investors!

• Berkshire Hathaway AGM this weekend!

• What are Owner Earnings? The way Buffett might think about Canadian National Railway

But first…

Fun chart of the day - U.S. energy companies continue to not over-invest. And real capex spending is really down much further from 2017-2019 given inflation.

 Berkshire Hathaway AGM this weekend

Some of us are attending the Berkshire Hathaway AGM this year again after a COVID hiatus. For those that haven’t seen the annual report cover yet, here it is. The retro 70’s style makes us think inflation is top of mind for Warren and Charlie.

The guide is here - https://www.berkshirehathaway.com/meet01/visguide2023.pdf

And for those that won’t be attending in person, you can watch the whole thing here - https://www.cnbc.com/brklive/

Old Old Pitches

Rick Guerin was a good friend and partner of Charlie Munger who was also great investor (33% for 19 years). Here’s his stock pitch of a leasing company back in 1962.

https://twitter.com/72types/status/1640699466494668801

Will North America have its own wave of Japanese-style zombie firms? We think yes

We continue to hunt for companies and have definitely come across a few that we view as being complete zombies, with higher interest rates creating more and likely finally tipping a few. But, how many of these companies are out there? Potentially a lot.

Bloomberg - Beware of the undead (company, that is). Tighter money policy is threatening to create new zombie firms — companies that struggle to service their debt, or banks that are technically insolvent — and kill off others that had been barely holding on. Zombies don’t just undermine investment, they can also cause job losses, reduced consumption and tighter lending.

Banks in North America, more so the U.S. than Canada, are more aggressive than Japanese banks in shutting down marginal business that can barely service their debt. However, this falls apart when a fat PE firm is involved, and will definitely fall apart if that PE firm has a huge portfolio of similar businesses, and the bank has an even bigger portfolio of similar PE-backed businesses in the same boat.

How to take a public company private – Denton’s

https://insights.dentons.com/464/27513/uploads/dentons---going-private-in-canada-brochure---english.pdf

What are Owner Earnings? The way Buffett might think about Canadian National Railway

To celebrate the Berkshire Hathaway AGM, we thought we would do a post about one of our favorite value investing concepts – Owner Earnings.

Warren Buffett coined the term "owner earnings" to describe a company's true earnings power. Owner earnings, as defined by Buffett, are the cash flows generated by a business that are available to its owners after accounting for all capital expenditures necessary to maintain the company's existing operations. In other words, owner earnings are the amount of cash that a business can actually generate that actually belongs to its owners, including both the cash that can be distributed to shareholders as dividends and the cash that can be retained for reinvestment in the business.

Let's say you are considering investing in a company that generates $10 million in net income for the year. However, the company needs to invest $2 million in new equipment and capital expenditures above depreciation reported in net income to maintain its existing operations. Therefore, the owner earnings would be $8 million ($10 million - $2 million). This is the amount of cash that the company can generate that actually belongs to its owners; if it is not reinvested the business will deteriorate (or just grow more slowly depending on what your scenario is).

The crazy thing we find is that this is often ignored by investors and even big firm analysts.

Canadian National Railway

Before we start, we want to recommend the book – “The Pig that Flew: The Battle to Privatize Canadian National" by Mark McLaughlin. It walks through the privatization of -Canadian National Railway and the challenges faced by the government and the opposition from labor unions, political opponents, and the public. Or, how to get a square peg through a round hole. If you are just being introduced to CNR, start with this.

Anyway, a real-world example of owner earnings that we think would be close to Buffett’s heart is Canadian National Railway. Obviously, he owns BNSF, but is familiar with CNR (and his close friend Bill Gates happens to own ~8% of the company).

Is CNR a good business? Yes. Can this misunderstanding of owner earnings still lead to a material difference in your expected return as a shareholder? Yes… Is this because of accounting shenanigans? No. It’s just the way accounting works and you need to be aware of this.

Here are the numbers. Since 2009, Canadian National’s actual cash capex has been ~104% higher than depreciation, and, because of this, adjusted “owner earnings” is ~36% lower than stated net income. 

Is this a problem? No, so long as you account for it. In CNR’s case, owner earnings have grown by 230% since 2009, or about 8.3% per year. It helps that gross profit margin and operating profit margin grew from 48% and 33% to 56% and 46% over this period.

What is driving this? Deregulation, consolidation, and discipline, with higher trucking costs sprinkled in – A Class I railroad is a term used by the Association of American Railroads (AAR) to describe the largest freight railroads in the United States. The Class I designation was initially applied to railroads with annual operating revenues of $1 million or more, but this threshold has since been adjusted for inflation. Obviously.

In 1940 there were 33 class 1 railways, and by 2021 there were seven. More interestingly, total track peaked in 1916 at ~254 thousand miles, decreasing to ~140 thousand today, while employment has decreased from over 2 million people in the 1920s to about 200,000 today.

For CNR, things have been pretty good.