OvaScience – Cash Flows Like Sand

Note: None of us own this or are providing advice. As always, do your own research.

 

Buying dollar bills for 60 cents is usually a winning strategy…unless of course, the dollar bills are being incinerated or being sold by someone else on your behalf for 30 cents. As we continue on our journey of value investing we should all be wary of value traps….

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Not necessarily related – but enter OvaScience! It’s a sad story, but sometimes things just don’t work out. It was once billion+ dollar market cap company that is “focused on the development of new treatment options for women and couples struggling with infertility.” About a year ago, the management team realized that <$100k in quarterly revenues was not sufficient to cover $14 million in quarterly G&A and R&D. After a severe restructuring this year, all but 8 employees remain in OvaScience as of September 2018. They did not reach the point of commercialization, as shown in their financials below:

With this newly lean, mean, non-revenue generating business model (as opposed to a large, cash-burning, non-revenue generating business model), OvaScience was able to woo Millendo Therapeutics into an all-stock merger. OvaScience shareholders would own ~20% of the combined entity. Millendo is in the middle of commercializing their own ideas as shown in their financials:

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The merger S-4 filed with the SEC makes for an interesting read. https://www.sec.gov/Archives/edgar/data/1544227/000104746918006443/a2236510zs-4.htm

 Let’s look at some numbers.

As of quarter-end June 2018, OvaScience had $48.3 million of cash and equivalents, net of all on-balance sheet liabilities, compared to a market cap of $27 million and change. Pro-forma for the merger, the combined entity would have $74.4 million of cash and equivalents, net of all on-balance sheet liabilities… which would be about $15 million ($74.4 X ~20%) for current NovaScience shareholders.

So OvaScience, instead of liquidating (recall – most of the employee severance had already been paid as of Q2 2018) and allowing shareholders to recoup let’s say around $40 million, decided that it was a “better” deal for shareholders to instead own 20% of a new entity, where current shareholders can claim interest to $15 million of net cash. Cash that soon, too, would be use for commercializing the next best thing.

Out of all of this emerges BML Investment Partners, which together with its principal Braden Leonard, have been buying OvaScience and recently raised their stake to about 10%. BML believes it would be better if “the company terminates the merger and liquidates.” The full filing can be found here: https://www.sec.gov/Archives/edgar/data/1373604/000156761918002599/doc1.htm

As individuals who (i) can add, and (ii) believe in the “bird in hand” concept, that might not be such a bad idea, in spite of the termination fee of up to $4 million to pay to back out of the merger.

We’re on the sidelines at the moment though, and wish BML all the best.

Corridor Resources Inc. (TSX:CDH) – Oil and Gas Stuck Between a Rock and a Hard Place

Note: None of us currently own this.

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What would you call a cash rich Canadian natural gas producer with good netbacks? There’s really only one thing you can call it - Corridor Resources Inc.

It’s 2014 – Katty Perry is near the top of the charts with Dark Horse and Corridor is riding high at over $2.00 a share. There is widespread optimism for Corridor’s New Brunswick natural gas properties and prospects offshore in the Gulf of St. Lawrence.

Fast forward to today – Katty Perry continues to have a great run but has unfortunately announced that she is going to “take a break” from making those great tunes, while Corridor can’t get a break. Their Quebec prospects are snuffed out by the province declaring the area their assets are in a UNESCO World Heritage site (leading to a payment from the province to Corridor of $19.5M). Their main asset in New Brunswick is performing well but there’s a fracing moratorium and the drama heats up with the David Suzuki Foundation going after their prospective licenses. This all comes to a head on June 12, 2018, when the Company announced it has suspended exploratory work on Old Harry (the gulf assets) for the foreseeable future.  

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Lemons to Lemonade

In spite of these challenges, the Company has done a remarkable job with their NB asset. When looking at them we think it is prudent to viewed and analyzed from when Steve Moran became CEO in 2014, where the Company’s various prospects and ventures pre-date him. Over the last four years they have hammered down costs and, as shown in the chart below, they have taken a very creative approach to natural gas production. There is a huge disparity between summer and winter prices at the hub they ship to because of certain structural capacity constraints, created by the same NIMBYism against fracing. They shut in for the summer and produce in the winter at hedged prices, which let them sell gas at a realized price of $12.90/mcf in Q1 2018. For context, gas in western Canada was trading at ~$2.00/mcf and cheap cheap cheap in the summer. Overall the hostility to natural resource development has been a net negative but this is definitely a case of turning lemons into lemonade. We don’t want to double up management’s comments, you can find a good discussion of the dynamics in their presentation: https://www.corridor.ca/wp-content/uploads/2018/05/Corp-Presentation-May18.pdf

What’s Up Today

Corridor currently trades at $0.66. Now this price is interesting for two reasons:

1)      From the various settlements and just plain cash coming in, the Company has stockpiled $56 million of cash.

2)      The Company is bringing in cash flow of ~$8-9 million a year with and has a market cap of $58.6 million and has natural gas reserves valued at PDP NPV10% of $55.1M (we’re using a different price assumptions. See our article on oil and gas 101 for discussion of reserve types).

3)      A + B leads to a market cap of….. $58.6 million… i.e. trading at half of book value.

 

So a Company with positive cash flow and lots of cash, trading at cash; what can they do?

Internal Options = not much

-Old Harry and Elgin Sub-Basin – They are largely dead. They are very complicated plays that would likely require a large partner and there is no appetite for fracing in Quebec/New Brunswick.

-Existing producing McCully field – Current management is taking a different approach than the prospector-style management team of yesterday. The Company would be hard pressed to further develop these assets. We believe the wells would cost something like $10 million each and the Company would want to spread the risk over several wells, with results likely lower return than other plays. This would be very hard to justify, particularly given the hostility towards energy development. We view these assets are going into a true wind-down.

External Options

-Idea #1 - They could do a deal with another junior. Based on the fact that they have already been sitting on cash for two years, it appears that they are very prudently selective on finding the right transaction. And frankly, we think it will be hard to find a transaction that is just right – not too big, not too small, and not too terrible.

-Idea #2 - Return capital

 Where do they go?

We think that this Company is a great example of management doing what you can with what you have. That said, the (local) world is against them on their home turf so they have to do a creative deal or ship the cash back to shareholders. There is one key shareholder based on filing - TCI Fund Management Limited with 19.5% we believe. They’re an activist fund but their holdings go back several years to the booms times for Corridor, where they are likely heavily underwater and they are not very active on this file (including their representative on the Board not attending a single meeting last year..).

 This is the strangest oil and gas company we have come across in Canada and is a good case study of how regulations can really hinder a company. They have done the best they can with the hand they were dealt and we’re on the sidelines and wishing them the best.

CBA Florida - The Curious Case of the Inefficient Market

In February of 2018, a little company named Cord Blood America, Inc. ("CBAI" or the “Company”, later renamed CBA Florida) decided it was time to sell its assets but no one seemed to care.. for a long while..

The Company issued a press release:

“On February 7, 2018, the Company announced that it entered into an Asset Purchase Agreement, dated as of February 6, 2018 (the “Purchase Agreement”), with California Cryobank Stem Cell Services LLC. Pursuant to the terms of the Purchase Agreement, FamilyCord agreed to acquire from CBAI substantially all of the assets of CBAI and its wholly-owned subsidiaries and to assume certain liabilities of CBAI and its wholly-owned subsidiaries. The sale does not include CBAI’s cash and certain other excluded assets and liabilities. FamilyCord agreed to pay a purchase price of$15,500,000 in cash at closing with $3,000,000 of the purchase price deposited into escrow to secure CBAI’s indemnification obligations under the Purchase Agreement.”

Fast forward to May 17 - the Company announced the transaction closed:

Cord Blood America Inc. closed the deal to sell its assets to privately held California Cryobank Stem Cell Services LLC, also known as FamilyCord.     

FamilyCord now owns substantially all assets of Cord Blood America and its wholly owned subsidiaries, and assumed certain liabilities.     

The deal was worth $15.5 million — FamilyCord paid $12.5 million at closing, and the remaining $3.0 million was deposited into escrow. Las Vegas-based Cord Blood said it plans to distribute a portion of the sale proceeds to its shareholders.    

As part of the deal, upon closing, the company changed its name to CBA Inc.     

Separately, CBA's board appointed Anthony Snow president and corporate secretary. Snow was appointed interim president in July 2017, following the resignation of Stephen Morgan as interim president, general counsel and corporate secretary.    

California Cryobank Stem Cell Services is a unit of California Cryobank Inc., a sperm bank in Los Angeles.    

 Here we have a pretty clean company, pretty clean transaction, an aligned “management team” – in fact there isn’t really a management team, where the annual report lists the address of Red Oak Partners LLC, a value oriented firm that is running the wind up (and 30%  shareholder listed in the filings).

Q1 2018 Balance Sheet:

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Yet after the announcement, they traded at a market cap of about $7M.. or less than 50% of the transaction price for two months. (For the math - They had an eye boggling 1.3 billion shares outstanding – or 1,272,066,146 shares exactly. Trading at $0.0055 = ~$7M market cap)

Maybe we don’t understand the math? Maybe we made a mistake..

And CBA continues to trade around there until exactly August 14th when they file their Q2 quarterly release. Over the next few days the stock jumps to a market cap of ~$10M, a gain of 30-40% depending on your in and out price and now a much more reasonable discount. If you read through the quarterly, they disclose that they closed the transaction to sell their assets, just as they did in May. But the difference between the quarterly report and the press release is that now the proceeds from the sale are reflected on their balance sheet – which then gets picked up by the folks running models/screens/and other such things.

Having two months to digest a press release is not so bad. Efficient markets indeed.

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Westjet Airlines Analysis: Headwinds – Time to buy a ticket and get on the plane? (TSX: WJA)

Disclosure: One of us owns this.

Have you ever been on an airplane in extreme turbulence? The plane is dipping like a rollercoaster. Up, down. More down. Your neighbor beside you is holding onto their seat for dear life, white knuckles and all. Well, much like panicky airline passengers… some investors in Westjet are likely holding onto their desk right now (or maybe a glass of sangria) with white knuckles too.

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Over the last 6 months the stock has hit quite the nasty air pocket, dropping about 35% to ~$18.  We are now not far off of the $15 bottom in 2016, which happened due to the (now over-hyped in hindsight) concerns over their exposure to Western Canada’s oil driven nature.

There are a few reasons:

-Fuel prices – Not a problem exclusive to Westjet but oil keeps on rising and as we write this article, prompt WTI is trading at ~$75. As a buyer of 1.5 billion litres of jet fuel a year, some think this is a major problem for Westjet.

-Strategy displeasure – Mr. Market is not happy with their plan. Originally Westjet was a simple Canadian copy of Southwest Airlines. Now they are launching Swoop and new international routes with new widebody planes. “Well, who are you? (Who are you? Who, who, who, who?) - I really wanna know (Who are you? Who, who, who, who?)”

-Pilot strike and associated cost advantage erosion – Westjet pilots recently voted to unionize and threatened to strike. A key crux of the matter was Westjet attempting to treat its low cost Swoop upstart pilots quite a bit differently than mainline ones. Thankfully this issue was resolved before one our last holidays! To resolve this though the Company and pilots agreed to binding arbitration, which is expected to increase labor costs via a deal similar to Air Canada’s long-unionized pilots. https://www.thestar.com/business/2018/05/25/threat-of-westjet-pilot-strike-over-as-airline-union-agree-to-settlement-process.html

-Increased competition from ULCC (ultra low cost carriers) in Canada – Most notably Swoop and Jetlines (and Transat flying around as well). You can see the two upstart strategies here:  https://jetlines.ca/strategy/ulcc-airline-model/ https://www.flyswoop.com/ultra-low-cost-carrier-ulcc-explained.html

-New CEO – In the middle of all of this excitement, the Company’s CEO Gregg Saretsky retired… abruptly in May and was replaced by Ed Simms. https://www.theglobeandmail.com/report-on-business/westjet-ceo-gregg-saretsky-retires-effective-immediately/article38247007/

Let’s evaluate these issues one by one.

 

But First - How have they done over the last 15 years?

To evaluate how Westjet has performed, we break it into two key items: Do they demonstrate 1) cost/margin control while growing, and 2) profitable growth.

Note: Before reading this article, we strongly recommend you read our article on the big four U.S. airlines and Berkshire Hathaway's 2016 purchase of about 10% of each, which can be found here.

1) Managing those margins

A key to airline profitability is ensuring your RASM is bigger than your CASM. RASM is revenue per available seat mile, which is basically total revenue divided by the total number of miles their planes fly. CASM is the cost of the mile. These are always measured in cents.

The table below shows how Westjet calculates their CASM. The industry as a whole is pretty consistent in the approach. However, three things to be wary of are: 1) depreciation and amortization calculations, where this is of course a non-cash estimate. Westjet is more conservative (read, less generous to itself) than certain other peers.. which we are happy about. 2) Maintenance charges, where airlines accrue major maintenance expenses based on the time to the next major maintenance event (say 5 years for an newish engine) and actual cash costs can differ – financial shenanigans (read, underreporting expenses) with this item would be a short-term gain long-term pain situation. We are not concerned here. 3) Management excluding “certain one-time items” from expenses. Westjet in general seems to have a lot fewer of these sorts of things than certain other peers.

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The table below shows how Westjet has performed going back to 2002.

Over the last decade the Company has grown seat miles by 8% a year, while maintaining an above 80% load factor and a 10% margin per ASM. Not bad.

But it is important to not just buy a plane but to use it. A great way to keep margins strong is to just fly your planes less! Westjet is getting about 185-220 million ASMs out of each plane (you can also look at hours utilized). Their utilization is down over the last few years but it is also at a time when they are growing their fleet materially and optimizing it.

2) How is that return on investment?

Part 2 – are they growing profitably. Both Westjet and Air Canada are kind enough to calculate that for you! (We still calculated it ourselves)

They calculate their return on investment very similarly – and we have included examples from their 2017 annual reports below. Basically they take before tax earnings + finance costs + implied interest on lease costs and divide by equity + long-term debt + off-balance-sheet leases. However, a few things to note:

-At the core – beware of estimates. Grossing up leases by 7.5x and assuming an implied interest rate of 7% seems reasonable (note that Air Canada grosses up by a smaller amount – 7.0x). They also both are affected by depreciation and maintenance cost assumptions and… one-time items.

-They both calculate before tax. One of us has strong feelings about this. If you could invest in a business that was making an annualized 30% return on a tropical island with 0% tax or a company making 30% in a business unfriendly place charging you 90% tax, which would you choose? Or, in other words, to ignore tax implications seems crazy but we are the only person on the plane screaming about this.

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Air Canada's:

 

Calculating returns - We prefer it our way.

The table below shows their after tax return on invested capital and after tax return on equity.

A 21% average return on equity for a decade is quite impressive, particularly when Westjet has also made ~$710M of share repurchases since 2010, including $90.3M in 2017.

 

Are fuel prices something to worry about?

If you take a look at our article on the U.S. airline industry (see it here), one very important key aspect of the thesis is that as an industry the airlines are practicing price discipline. The thesis is that as an industry they are diligent about not creating too much capacity and maintaining airline ticket discipline as well.

As all Albertans will remember, oil dropped quite dramatically over 2014-2016, bottoming out at @$27/barrel in January of 2016. We took a look at how Westjet’s RASM and CASM correlated with jet fuel prices. Fuel has represented about 20-30% of operating costs in recent years. As expected, Westjet benefited from lower jet fuel prices but only temporarily as airline prices industry-wide as a whole drop.

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Going forward, we expect the same to hold true for rises in jet fuel costs, albeit likely more slowly - No one wants to be the first to increase their fare price. That said, we view there being no permanent decrease in airline margins because of this.

One wild card is if oil and jet fuel increase so significantly that they materially reduce the affordability of flying leading to an industry-wide reduction in flights taken. Fuel is only 20-30% of costs and airlines were just fine when oil was $100. Or in other words, if oil hits $200 a barrel there are probably a lot bigger problems in the world than the cost of your next flight to Hawaii. 

The Strategy Change….

As we discuss in our recent airlines article (see here), Warren Buffett made a significant investment in the big four U.S. airlines (approximately 10% of each). While we are still waiting for him to call us back, we believe that the thesis is that the large North American airlines have significantly changed how they operate, are being more diligent with their capital, and also have numerous scale and regulatory advantages that has created a moat.

Going back to the roots of Westjet, it was born in 1996 as a simple low-cost carrier with a strategy copy-and-pasted straight from Southwest Airline’s latest investor presentation at the time. Simple plane fleet (Boeing 737s), non-unionized pilots and flight attendants, and good incentive pay for these staff instead of unionization.

It worked extremely well for awhile. A long while. But the world has changed. Co-Founder, former CEO, and Chairman Clive Beddoe continues to have significant influence on the Company. Clive has been instrumental in the original strategy and helping the company adjust course. For example, he pushed forward the Encore subsidiary strategy. These movements 1) mirror what U.S. airlines are doing (regional subsidiary feeders for example) and 2) are in line with what we think they should be doing. As a side note, Clive was likely a very key part of the CEO change, and we are just fine with that. He has a good track record of pointing Westjet in the right direction.

In a significant oversimplification our previous article – To remain competitive, airlines need:

1) Scale – bringing cost of capital advantages, purchasing advantages, and ability to handle increasingly large regulatory burdens. It should be noted that Westjet maintains an investment grade credit rating and is de-levering.

2) An expanding web of marketing and partner agreements and rewards schemes – We discus this in depth in our other article, where airlines can maintain higher more profitable load factors by creating partnership agreements with other airlines. In Westjet’s case, they are expanding their partnership with Delta among others noted below and have been very successful with their RBC Mastercard offering. http://www.travelweek.ca/news/analysis-westjet-and-delta-want-to-expand-with-a-joint-venture-whats-the-impact-for-the-travel-industry/

We view Swoop and the 787 dreamliner (i.e. international flights) as extensions of the above items and a rational response to the changing environment. Both Westjet and Air Canada now operate low cost carriers and international flights, which must be quite discouraging for any competitors out there (Canada is a small market after all). Frankly, our view is that the competitive nature of the Canadian airline industry makes it very unlikely that any of the upstarts are able to become the next Westjet and instead will likely only have success on certain specific routes. The entire North American airline industry has gone through a long history of capital destruction and the transition to large scale financially strong stable airlines is a rational if not the healthiest outcome.

Note on unionization - It should be noted that we believe that Westjet becoming unionized was inevitable and we are not concerned about it. As an industry it is becoming more regulated, including rules around pilot and flight attendant scheduling, and as an industry it is significantly unionized already with no one really having a material labor advantage over others. We expect that Westjet’s overall employee cost per job role will be very similar to Air Canada and view this as a permanent erosion of this cost advantage.

 

Valuation – What would you pay for that ticket?

The core of our thesis is that Westjet will continue to do well but not as well as before. We believe that there are is permanent reduction to their cost advantage vs Air Canada. But that’s OK and assumed. Secondly, the Swoop and international expansion are rational changes in strategy and ultimately it is not a great environment for upstart competitors. Canada is a small market after all.

Westjet is targeting to grow its fleet from 167 to up to 265 by 2023-2027 and expects to be able to grow its fleet over the next few years while still having free cash flow (we agree with this). Looking a few years out, you would be sitting on a 3-6x P/E investment based on the current share price and the assumptions below.

We expect that the next 20 years will be harder than the last 20 for Westjet but you don’t have to keep getting rich at the same rate you have in the past.