AlarmForce (TSX:AF) – Why did 3G Buy and Sell AlarmForce? And why didn't we buy it?

Whenever you can, you should check your original investing thesis and see how things turn out.

In November of 2017 BCE Inc. (Bell) (TSX:BCE.TO) (NYSE:BCE) announced was going to acquire AlarmForce Industries Inc. (TSX:AF.TO), Canada’s lone public home security and monitoring services company, for approximately $166 million ($16/share).

We took a look at this company in November of 2016 (a year before almost exactly to the day). At that time it was trading at ~$10/share. The Company had a new management team, was in the middle of a brand and product refresh, and started outstourcing product development. Our conclusion was “wait and see” in the sense that we liked what the Company was doing but things were just too unclear for us to buy – effectively it was execution risk. Full details here: http://www.canadianvalueinvestors.com/home/2016/11/17/alarmforce-tsx-af-will-they-keep-your-dollars-safe

Interestingly, Pavel Begun, Managing Partner at 3G Capital Management, recently spoke at Ivey Business School and covered why they bought the business originally:

3G owned AlarmForce for just about a decade before you sold it at the end of last year [2017]. Would you be able to walk us through your original thesis as well as why you sold?

The original thesis was that you had this business that had a significant competitive advantage within an industry where everybody else did things in a highly inefficient manner. So more specifically if you look at the home alarm industry what you see is that pretty much all the players distribute their services through a network of dealers. Unlike everybody else AlarmForce distributes its products and services direct to consumers, so they take out a huge layer of cost, and as a result they were able to sell their product and service cheaper than everybody else. And yet they still enjoy a significant margin advantage. So, when I looked at AlarmForce and the structure of the industry it reminded me of GEICO back in the day because GEICO had a very similar industry structure and a very similar advantage. And with AlarmForce I thought well look, you are going to be in this large and growing industry, you have probably 1/10th of 1% of the market share, you have a significant cost advantage versus everybody else, and you have the industry structure that restricts adaptation because if you sell through dealers it’s very hard for you to say well I’m just going start selling direct because that’s going to, I guess this, piss off your network and they might leave.

So that was the theory and it was working well early on for the first maybe four or five years and then things got off track a bit. There was a significant technology change within the industry, there were changes to marketing channels, and there were changes to the product suite as well. And those were tough challenges, but they were not insurmountable, so I think you could have overcome those challenges. But management struggled to do it, so the company did not grow as much as I originally expected.

But in in the right hands that business was still worth a lot of money because at the core they still retained their low-cost advantage and the industry structure was still such that existing players could not adapt their marketing strategies to sell direct. And that was not lost on potential buyers and in November of last year Bell decided to make an offer for AlarmForce at a 65 or 75 percent premium and so we ended up selling. So, we really didn’t have a choice but at the end of the day we still earned a good IRR depending on the time of purchase and the price of purchase, because we purchased AlarmForce at a number of different times at different prices. We earned anywhere between 14 to 23 percent IRR on that investment.

Lesson learned: Keep checking your thesis, and make sure you didn’t miss anything that you could have foreseen.

3G’s initial thesis was good. The world changes and in this case unforeseen technology changes eroded some of AlarmForce’s business and advantage, but the core thesis that they had a structural competitive advantage – by not having to rely on a network of dealers – remained sound.

And us? We missed out on a 60% upside in one year, sure, and on the day of the announcement we definitely had FOMO. But after reviewing the situation, it was not foreseeable that they were going to be bought at this time (although it is a logical outcome). There was still a lot of execution/management risk (something that 3G would have had much more insight into as a large long-term shareholder and they also had a Board seat) and 3G also benefited from a lower cost base vs where the shares were trading when we reviewed the Company.

2008 Globe and Mail Article on 3G's purchase/thesis

https://www.theglobeandmail.com/report-on-business/alarmforce-secure-growth-and-the-stock-may-be-a-steal/article17985404/

2017 Bell Acquisition Announcement

https://www.theglobeandmail.com/investing/markets/stocks/AF-T/pressreleases/5325377/

Peyto Exploration (TSX: PEY) $11.00 – What's wrong with Peyto? (Cheap Gas, Even Cheaper Peyto)

 

DISCLOSURE: Some of us own this.

Back in February of last year, we did a write up on Peyto Exploration, noted as having what we believe to be some of the best natural gas assets in Canada led by a very focused and diligent management team (see our write up).

http://www.canadianvalueinvestors.com/home/2017/2/11/peyto-exploration-tsx-pey-2800-a-great-company-stuck-in-a-cheap-gas-world

Since we wrote Peyto has declined from $28.00/shre to ~$11.00, a tremendous drop that has happened along with most of the Canadian energy patch. A drop like that deserves a revisit.

So, what’s the problem? Canada is 1) at the start of the pipe for both natural gas and crude oil – where most of it gets shipped to the U.S. or back east and 2) Canada can’t seem to get any new pipelines built – either oil or natural gas. While U.S. WTI oil has had a nice run up and natural gas has held up (at approximately $3.00 / MMBTU per below), realized current and expected future prices of Canadian producers have not. 

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Source: https://www.eia.gov/dnav/ng/hist/rngwhhdm.htm

 

Canadian Natural Gas – What’s happening?

While there are issues with oil differentials, we want to focus on natural gas and the following chart says it all. Since this time last year the curve has shifted dramatically, with natural gas this summer floating around $1.00/mcf compared to ~$2.40 a year ago. To put this into perspective, Peyto’s best in class all in cash cost to get gas out of the ground (operating costs + transportation + G&A + interest) is approximately $0.70/mcf. And there are some assets in western Canada that are closer to $3.00 breakeven (never mind recovery of capital, or a return on investment..).

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Source: http://www.gasalberta.com/gas-market/market-prices

 

Peyto – A “Defensive Bias”

 In response to this absolutely brutal pricing environment, Peyto has materially cut its capital program, cut its dividend almost in half to $0.06/share/month (from $0.11), announced a share buy back plan, and says they will shift capital to more liquids rich properties (which we also believe would have a higher ROI based on today’s prices). We agree with all of their decisions, though would strongly prefer for them to have eliminated the dividend completely and instead focus on debt repayment and share repurchases. You can’t always get everything you want though right?

Analysis – What do you get if you buy today?

When we’re looking at Peyto, we’re 1) very comfortable with the management team and the asset base and 2) don’t believe that $1.35 AECO gas prices are sustainable, but also don’t know when they will recover and what “recovery” would mean.

 This leads to two questions: 1) Can Peyto survive and prolonged downturn and 2) At today’s stock price, what natural gas price do you need for a reasonable return?

Scenario 1 – Cheap gas through 2021

 Under this scenario, we assume: 1) gas is $1.35 for the next three years and “recovers” to $2.50 in 2021, 2) the Company manages is debt profile to stay within covenants (3.00x max), 3) prudently eliminates its dividend in 2019, and 4) begins to increase capex again in 2021.

Long story short, Peyto survives (helped by their strong hedging program) and you end up buying an asset today at ~9.5x 2021 free cash flow.

Scenario 2 – A bit faster recovery, return the growth

 Under this scenario, we assume gas (and capex) increases to $2.00 in 2019, and $2.50 in 2020, and have run both a $2.50 and $3.00 2021 scenario. Under this scenario you are getting the company for between 6-10x 2021 FCF.

Things we don’t consider

Our mindset is not “What will happen?”, but rather, “What is a reasonable conservative base case and would we be happy with this based on today’s share price?” We consider three years at $1.35 and an improvement to $2.50 a pretty conservative case (reasonable considering a US$3.00 MMBTU Henry Hub price), and under this you get a company for 10x FCF. We don’t consider things such as share buybacks, the impact of a shift in capital towards liquids rich wells, or improved capital efficiencies. These are basically free upside options and our analysis does not depend on them happening. 

We’re not sure where commodity prices are going to go but this is potentially the best risk/return buying point in Peyto’s recent history. In the meantime, Peyto will keep on standing.

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Don Gray and Peyto Exploration - The Early Years

Back in February we wrote about Peyto Exploration, an outstanding natural gas company stuck in a cheap gas world. For a refresher see here.

Natural gas prices remain stuck for Canadian producers (and are particularly challenged as we write, with AECO September contracts looking quite ugly at only ~$1.40/mcf due to egress issues), but Peyto continues to chug along with a healthy hedge book.

The original President and CEO of Peyto was Don Gray, a very colourful and outspoken character in the oil patch (he is currently the Board Chairman). We found a great article from the Globe and Mail written in 2004, where at the time young Peyto was only six years old. 

What's fun about the article is how Peyto's strategy remains the same as today and the complaints about Peyto's strategy haven't changed either. 

Still, numbers such as that $300 million in 2005 capital spending get people talking about Peyto's future, asking the same question that's been asked all along: How long can this keep going? "They won't have $250 million or $300 million of projects every year," says Mark Bridges, an analyst at CIBC World Markets Inc. Gray's projection of doubling production to 40,000 barrels a day by the end of 2007 will be "pretty tough" to meet, Bridges says. "When they acknowledge things are slowing down, that's when the hit will come.

Peyto's 2017 budget is over $500 million and production is over 100,000 boe/d with further growth plans in place.

Gordon Zive of RBC Asset Management sees around four more years of drilling opportunities, but he also has perhaps the most pragmatic warning. "When you're young and you've been successful, you become complacent and, therefore, vulnerable to a shakedown. ... In the fullness of time, guys like [Gray] who think that they're almost infallible because of their success, are the ones who fall the furthest. ... I've seen that happen many times. I think Don Gray is an excellent example of a guy who's setting himself up for that fall."

"Guys think we're running out of land all the time," Gray says. [Rick] Braund laughs at the notion that Peyto is hemmed in: "That'd be bullshit."

We're glad Peyto didn't run out of drilling opportunities in 2009. Don Gray was focused on creating a strong cost efficient energy company, owning their own infrastructure, and remaining extremely focused. He was also more than happy to tell everyone else they were doing things the wrong way. 

Gray sees little original thought in the oil patch, just a bunch of people chasing the latest trend. "I see them almost as cowards," Gray says, adding that people become too averse to risk as they climb to the top rungs of the business. "They're quite happy with just being average, being the mediocre....It's hardly my competitors that challenge us. It's more my mouth that challenges us."

The article provides a surprising amount of background and insight into the early years of Peyto and really gives you a feel for how Don and the Company were perceived (and of course, can now be compared to the actual outcome). Here's the full article: https://www.theglobeandmail.com/report-on-business/rob-magazine/don-gray-is-the-biggest-jerk-genius-in-the-oil-patch/article18280515/?page=all

*If the article is no longer available by the time you read this please let us know and we can send you a saved copy. 

 

Mainstreet Equity (TSX:MEQ) The Apartment Tycoon – Investing in Real Estate Differently

Disclosure: We own small positions in this company.

Mainstreet Equity is a bit of a different company. Unlike your typical public real estate company, they do not pay a dividend. They do not buy a few large income producing towers and sit on them. Mainstreet is a bit more fun. They: 1) buy underperforming or distressed mid-market apartment buildings in Western Canada, typically only a few floors high, 2) upgrade their insides, improve energy efficiency and curb appeal, 3) increase rents and refinance them using larger low rate mortgages, taking out most of their initial equity, 4) profit. The Company’s argument is that these properties are selling significantly below their replacement value (the cost to build a new building), particularly after they have been renovated.

Bob Dhillon is the CEO and founder. This is his baby and owns approximately 43% of the Company.  This strategy has been stated and executed consistently by him and his team since its founding. They also have a history of disciplined buying, which we like. For example around 2006, Calgary property prices were not meeting their required returns, and instead they focused on Saskatoon, southern B.C. and Edmonton where there was less competition (Mainstreet started buying in Calgary again in 2010). Mainstreet also acquired properties in Ontario but prudently decided to exit the market in 2012 due to valuation/return concerns and high competition compared to its other markets.

The Company has grown quite remarkably from 1,370 units in 2000 to 9,936 at the end of Q1 2017. This has also been done by only reinvesting cash flow and new mortgages since the mid-2000s with no new equity (with the exception of options issued in the early 2000s). Mainstreet has actually been buying back a significant number of shares over the past few years (see below) as the Company views itself as being undervalued. Apartment units per million shares (a fun metric we have made up) has grown 148 in 2000, to 513 in 2009 to 1,119 at Q1/17. 

Mainstreet seems to renovate very efficiently where they actually have an office in China to buy materials in bulk. The strategy also incorporates technology and methods like clustering of properties to reduce costs (e.g. share maintenance teams and managers across multiple buildings). They seem to be managing operating and G&A costs per unit effectively, but not amazingly, which is just fine.

As with most real estate companies, debt is heavily used but maturities are managed well. There has been a string of recent refinancings continuing the trend of reducing the Company’s average interest rates. “During Q1 2017, the Corporation refinanced $50.1 million of pre-maturity mortgages and incurred pay-out penalties in an aggregate amount of $1.9 million. The refinancing reduced the average interest rate from 5.24% to 2.44% resulting in annualized interest savings of $1.5 million and raised additional low cost capital of $49.5 million after pay-out penalty for further growth of the Corporation.”

Valuation – What is it worth?

We believe that this Company is potentially undervalued because: 1) general concern over western Canada (if it's cheap enough we don’t mind), 2) they do not pay a dividend (we don’t mind if they are investing profitably), and 3) reasonably low liquidity and float (which we don’t mind).

When we are looking at this Company to see if it's undervalued, we have focused on two things: Cash flow per share and NAV per share. The Company is trading at approximately 57% of Q1 2017 net asset value. One could argue that NAV could be overstated but on a cap rate and per unit basis it seems reasonable and also buying below 60% seems to provide decent enough cushion for price decreases / overvaluation issues. Secondly is cash flow. Assuming 2015 cash flow and the current share count, the Company is trading at approximately 10x normalized cash flow (not bad at all). The thought process is that they can get to $3.50 a share through stabilization of existing properties, rents stabilizing in their key Alberta markets, continued asset growth, and other efforts like refinancing debt at lower rates. We are not projecting what cash flow will be next year; we are more focused on the general direction. These things all move cash flow in the right direction.

Of course, do your own due diligence. A few of the things to look out for:

  • Lot’s of debt but used consistently over its history with increasing focus on long-term CMHC insured debt.
  • Shares frequently “undervalued”.
  • Very frequent acquirer/seller making it very difficult to calculate normalized profit/cash flow and creates noise about gains and losses.  For example, in 2008 stabilized properties had FFO of $5.84M while non-stabilized properties had a loss of $2.1M.
  • Assets now valued at “fair value” since the adoption of IFRS. The cap rate has decreased over time (not exclusive to MEQ) but stabilized and actually increased in 2016 (as it should in a down market).
  • Maintenance capex. We have not gotten to the bottom of this.