power-generation

What do Game of Thrones and investing have in common? A lot, if you ask the founders of Broadview Capital Management, which has been managing money for high-net-worth and accredited investors since 2009.

Lee Matheson and Anthony Hammill cannily use pop culture—be it references to the popular fantasy show or samurai metaphors—to explain their philosophy and investment decisions in monthly letters.

In the team’s January 2016 letter, for instance, they compare their decision to hold off buying during market turmoil to fending off pillagers in Game of Thrones. “They are unthinking, unemotional and know but one thing—destruction. To put it mildly, they cannot be reasoned with. This is what trying to pick stocks in this environment is like.”

The colourful metaphors ultimately deliver thoughtful analyses, and encourage clients to actually read the full document.

“It’s been one of our principles since day one: not delivering clients a letter that could have been written by some sort of robot,” says Matheson, adding that Hammill writes most notes. Clients aren’t looking to the firm for headline news; they want to understand what the firm is doing to protect their portfolios.

Investors learn that the firm generally takes long positions, but does hedge and short. They’ll also learn why the team—self-described curmudgeons—is skeptical of securities that other equity managers love. (“[W]e will continue to be vigilant in looking out for the next wave of garbage barges that get foisted upon the Canadian investing public,” they write.) Investors will also learn about the firm’s losses, and any missteps.

In 2015, Broadview’s return was 5.41% annually, net of fees and expenses. Since the fund’s inception in April 2009, its annualized return is 13.9%.

Hit

Atlantic Power Corp. (ATP.DB.U and TSX: ATP)

Headquartered in Boston, Atlantic Power owns and operates 23 power plants in nine U.S. states and two Canadian provinces. Plants are powered by coal, natural gas, hydro and biomass. It sells the power on to utilities and other users.

Putting it through their process

The company delivers total returns at low volatility, which Matheson says attracted retail investors “who generally aren’t sophisticated enough to understand the nuances [of] power generation assets.”

In 2013, Broadview saw a paradox between Atlantic’s stock and debenture prices. Its convertible debentures were trading at 50 to 70 cents on the dollar, implying holders didn’t think the company could make good on its debts. But its shares were trading at $3.30, giving it a market cap of $400 million. Matheson and Hammill started crunching the numbers. “We built a model on each asset within Atlantic Power, each power plant, and what we thought it was worth in a transaction,” says Matheson.

It’s difficult for casual investors to value power-generation purchase agreements. “You really need to understand when these contracts expire, what the market power prices are, and economics in those markets in order to determine what these things are actually worth,” says Matheson. Many investors don’t know how to do that.

Say a contract struck 20 years ago has a high unit price for power but, over the years, the market price drops. While the contract was still in place, the generator was guaranteed the high price but, on renegotiation, it may not get such good terms. In that case, “the cash flow stream that you had gets obliterated.”

Broadview’s team sorted Atlantic’s contracts by value. Then Matheson and Hammill compiled a total for the company, minus debts. They arrived around $200 million—much less than the market’s $400-million value.

In January 2014, the duo bought a block of Atlantic Power’s longest maturity U.S.-dollar convertible debentures at 58 cents on the dollar. At the same time, they shorted its common stocks at $3.30. They bought about twice as many debentures as they shorted equity.

Turning point

In September 2014, Atlantic’s president and CEO left the company. The COO left in February 2015. Over the past three years, the stock had gone from $15.12 to $2.14. Under a new president and CEO, the company sold its high-value wind portfolio in June 2015 for US$347 million. The price was on the higher end of Broadview’s expectations. “That really recast the balance sheet,” says Matheson.

In the meantime, the company’s dividend was declining. Atlantic paid shareholders 0.096 cents a month in 2012. By 2015, it was 0.030 cents quarterly. In February 2016, it was cut entirely.

From Broadview’s perspective, the dividend cuts were good. Investors who had bought a dividend payer were disillusioned, its stock price dropped and the firm’s short position paid off. The convertible debentures benefited too, because money would go toward servicing debt. In fact, Atlantic used its proceeds from the wind sale to pay off US$310.9 million in senior unsecured notes.

Post-purchase performance

As the debenture’s prices fluctuated, the firm sold and re-purchased its position, making gains. In July 2015, it sold some of its bonds at 85 cents. Overall, Matheson estimates his company got a 10% yield. On the shorts, Broadview paid to borrow the shares and cover the dividend. Before those costs, the firm made $1.65 per share; after paying the dividend, it netted $1.30. Broadview continues to hold debentures.

Power generation demands a knowledgeable investor, says Matheson, but he’s been to investment conferences where portfolio managers don’t ask company executives questions about how the business works, for fear of looking silly. Instead, they discuss dividends and price versus earnings. “It’s crazy to think that someone who has a general financial background is going to […] naturally understand the nuances of any given business.

“The issue is, do you know what you own? Not a lot of people do.”

Miss

Genesis Land Development (TSX: GDC)

The Calgary-based land developer buys plots of undeveloped real estate and gets municipal development permits. Founded in 1991, it also installs services like power and sidewalks, and either builds homes and communities on the land itself or sells the land to other developers.

Putting it through their process

Matheson started looking into Genesis in mid-2012. He and Hammill read all the business’s public financial documents, competitor’s filings and industry newsletters, building a model of the company’s value.

Land development businesses don’t conform to traditional metrics, making them hard to value, says Matheson. Revenue and profits aren’t consistent because the developer spends up front to buy land, get permits and install utilities. It could be years before the land or homes are sold and the project is profitable.

In 2011, Genesis’s CFO and CEO settled with the Alberta Securities Commission, which alleged the company wasn’t reporting its finances properly. Management had since changed, but Matheson says the regulatory trouble meant the firm was undervalued.

Genesis regularly published its net asset value. Based on his research, Matheson thought the company’s NAV of about $7 (roughly double the stock price at the time) was too high. The NAV is unscientific, he says, because it’s based on assumptions about land demand, macroeconomic conditions and other projects in the market, years from now. “It’s effectively a discounted cash flow model on each of the projects,” he explains.

While he didn’t agree with the number, he wondered why the company’s new management would endorse such a high value. “If that number ends up being erroneous, there’s a potential liability—and certainly a reputational liability—to all those directors.”

But Matheson liked that the company was relatively debt-free. Since it didn’t have traditional cash flow, he measured the company’s debt minus cash against its book value. At the time, the ratio was 0.2. “In effect, the large majority of the underlying assets were unlevered,” he says.

Another positive: Genesis had bought its Calgary land in the early 2000s, when it was still fairly inexpensive. “Where you’d be concerned when buying a Calgary land company is if they bought the land at some peak in the [real estate] cycle, and therefore the value is potentially overstated.”

More than metrics, it was another Genesis investor that made the investment attractive, says Matheson. A new private fund called Smoothwater Capital owned a third of the company. It’s financed by Weston family member Garfield Mitchell and run by Stephen Griggs, former executive director of the Canadian Coalition for Good Governance, a group of activist institutional investors. Griggs also had experience as head of a major Ontario pension. Matheson believed Smoothwater wanted to make its name as an activist on its Genesis investment, and use its new clout to attract outside backers.

In Matheson’s view, there were two ways for investors to profit.

  • On the public markets: as the new management team restored the company’s reputation, other investors would buy in, pushing the stock price up. At that point, Broadview would sell its position.
  • Private buyout: Smoothwater or another private entity would eventually want to own the entire company, paying Broadview and other shareholders a premium.

At the time, “we [didn’t] really understand how this [company’s future could] get messed up, so we [were] pretty excited about it,” says Matheson. Broadview purchased Genesis stock in April 2013 for $3.39 a share. It held a 3% stake in the firm’s portfolio. “For a while, it actually went the way we thought it was going to go,” he says. “Then the story falls apart.”

Turning point

Broadview wanted Genesis to buy back more stock, helping shareholders realize some of the company’s value. Company management didn’t agree for two reasons, says Matheson. First, buying back shares could’ve pushed Smoothwater’s stake to 50% or more, and the other board members didn’t want to cede control.

Smoothwater’s Griggs, who became interim CEO of Genesis in February, says Genesis regularly buys back stock through normal-course issuer bids, but it needs to preserve capital to use in the business. “No one can determine how deep things will get in the Calgary market, in terms of a slowdown in sales, and no one knows how long it will be,” he says. “We are well positioned to weather a significant downturn.”

Matheson thinks the second reason Genesis’s management turned down buying more stock is because they wanted to create more stable revenue for the company. By buying more land, there would always be projects at different points of development. Genesis told investors it could do this by buying $10 million to $15 million worth of land, he says. That seemed reasonable at the time, but the company ended up spending $52.5 million on one purchase. Since the deal was so big, Matheson says Genesis’s management told him it planned to lessen the financial burden by parceling off the land to other developers, but they weren’t able to find buyers. Griggs disagrees, saying there was never a plan to find other buyers, because Genesis had enough money to buy the land outright.

Regardless, the deal’s timing was poor. Genesis bought the land in early 2015, before the oil market took another plunge, says Matheson. He thinks the oil patch land was overpriced.

Post-purchase performance

Broadview’s first investment thesis, a recovery in the public markets, had started to play out in summer 2014, when the stock rose to a longtime high of $4.82. The fund sold a block of its shares in August 2014 at $4.79 a piece, but still holds some today.

In 2015, Genesis lowered Broadview’s absolute return by 1.2%. As of mid-March 2016, the stock was worth about $2.43. “It’s small cap, it’s illiquid, it’s in a resource-heavy geography, [and] there’s really no sell-side analyst coverage or anybody to promote it,” notes Matheson.

Griggs says the market is undervaluing Genesis right now because it’s a small-cap Alberta company. He’s optimistic it will rebound when the economy does. “The economy tends to recover very quickly in Calgary, and with our lands being [priced] primarily at the entry level or near-entry level,” he says, “we think we’re very well positioned to take advantage of a bounce back in the Calgary market.”

As for Matheson, he says a private buyout, possibly by Smoothwater, as well as another investor, is now the best outcome. The high NAV, which was endorsed by Smoothwater and the rest of the board, would force the buyer to offer shareholders a much higher price than what the stock is currently trading at, he says. “If Smoothwater wants to [buy] it from us for a higher share price […] at least it gives us a big premium over where it’s trading today.”

Meanwhile, a new activist investor has acquired about 15% of the stock, and is trying to oust Smoothwater. “He can make life miserable for Smoothwater and be a thorn in their side,” says Matheson, “but can’t really affect much change.”

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Jessica Bruno is a Toronto-based financial writer.

Originally published in Advisor's Edge Report

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