Marketdepth

The Shoeshine Portfolio - 2010 Edition

 

When I was a kid growing up in Kelowna, we used to have a summer fair called the Regatta.  Originally oriented around sailboat races, by the 1970’s the Regatta’s main attraction was its fairground rides.  Long lines always formed in front of the huge red and white Salt and Pepper Shaker, which towered over City Park.  I can still remember clinging to my seat straps – in complete terror – as the Salt ‘n’ Pepper Shaker’s passenger capsule plunged towards the earth while spinning, before rocketing back skywards.

 

 

Figure 1: The Salt ‘n’ Pepper Shaker Towered over City Park

 

 

 

As an investor looking into 2010, this scary ride is brought to mind unaided.  No doubt we will survive this coming year just as we survived the questionably maintained fairground rides of the 1970’s.  However, I make no promises about our condition upon exit.  Given the economic turbulence that appears likely to come our way in 2010, losing our lunch strikes me as a definite possibility.  The trick, as always, will be to avoid losing our shirts.

 

Avoiding Real Estate, Seeking Liquidity

 

For next year, a critical strategy will be to insulate oneself as much as possible from a long-overdue housing bust north of the 49^th parallel.  Forget the bloggers, warnings about a Canadian housing bubble are now coming from bank presidents.  Adding urgency, the federal Minister of Finance now seems intent on kicking out the legs from under the housing market by reducing the mortgage credit availability that drove prices into the stratosphere in the first place.

 

A second key theme for the 2010 portfolio is liquidity.  In the long run asset prices rise, driven largely by growth in money supply.  But in order to prosper in the long run, one must first survive a succession of short runs.  There are too many people in Canada between 30 and 50 years old who have some home equity, a lot of mortgage debt and precious few other assets.  In order to make it through to the “other side” of a housing bust these folks need to line up liquid assets or sources of guaranteed borrowing that could see them through a rocky patch.  Insolvency (owing more than you are worth) is unpleasant, but it is not financially fatal unless combined with illiquidity (having no cash).

 

Shoeshine’s 2010 Portfolio

 

As for what to own, I offer the Shoeshine Portfolio, a hedge fund in a box.  I have covered many of these securities in recent posts and present a summary rationale here.

 

Figure 2: The Shoeshine Portfolio for 2010

Category	Symbols	Name	Weight
Cash and Equivalents	C$, US$, HK$	N/A	30%
Precious Metals	NYSE: SLV NYSE: PTM NYSE: GLD TSX: CEF.A	i-shares Silver Trust E-TRACS Platinum SPDR Gold Central Fund	60%
Inflation-Protected US Treasuries	NYSE: IPE	SPDR Barclays TIPS	10%
Equities (Long)	TSX:COA TSX: SVM NYSE: CSH NASDAQ: CSCX NASDAQ: GPC HK: 341	Coastal Contacts Silvercorp Cash America Cardiac Sciences Genuine Parts Café de Coral	50%
Equities (Short)	TSX: XFN	iShares CDN Financial	-50%
Total			100%

 

 

Cash is not held for a return at these rates, but because it may come in handy.  I prefer US dollars to Canadian cash these days for the simple reason that a US dollar has more purchasing power without a materially worse fiscal position.  Cash in fundamentally undervalued currencies pegged to the US dollar (like the HK$) also looks sensible here. 

Precious metals in the long run will be worth much more than cash and so deserve a bigger weight.  My value favourite in this category is silver, but all should do well.  US inflation-protected Treasuries are an alternate means to preserve capital.

 

And as for equities, I’m happy to own a boatload, provided I offset my favorites against short positions in the handmaidens to Canada’s housing bubble that populate iShares Canadian Financial index.  In their stead, I propose a selection of businesses that earn money from online contact lens sales, silver mining, pawn broking, auto repair and fast food meals in China.  For good measure I add a Washington state business (Cardiac Sciences) that trades well below cash value.

 

Are you ready for the Salt ‘n’ Pepper Shaker of 2010’s financial markets?  Hold on tight, it should be quite a ride.

Coastal Contacts - A Hanging Curve Ball

Every now and then you unearth a stock that just seems too cheap, regardless of what is going on in the rest of the universe.  Seeing as it is World Series time, it seems appropriate to post on the stock market’s equivalent of the hanging curve ball.  Disagree if you must, but my nominee in this regard is Vancouver-based Coastal Contacts Inc.

 

Coastal Contacts is Canada’s leading retailer of contact lenses.  In fact, after US-based 1-800 Contacts, Coastal is the second largest online contact lens distributor in the world.   Trading at $1.25 per share, Coastal might fetch twice that amount were it to be acquired by one of several potential suitors.

 

Figure 1:  Hanging Curve Ball, Meet Mr. October

 
 

Coastal is still enjoying the earlier stages of a penetration curve.  Where traditionally contact lenses were dispensed by opticians, the market is shifting towards online distribution.  The key driver, not surprisingly, is significantly lower prices.  Online suppliers charge about half of traditional clinic-level costs.  Benefits packages that cover only part of the cost of a traditionally filled contact lens prescription go much further online.  And for the increasing number without benefits, the choice is clearer still.  Consequently, Coastal Contacts continues to post mid-teens annual sales growth – not too shabby in the best of times, but almost unheard of in 2009.   And there is much more market share to be gained from dispensing opticians, who still hold more than 85% of the $5 billion global contact lens business.

 

Coastal is more than just a Canadian operation, earning more than 80% of its revenues abroad.  Coastal is the market leader in Sweden, Norway and a number of other non-US markets. Coastal’s scale supports its ability to carry over 100,000 sku’s in inventory, which allows it to deliver faster service to its customer base.  Volume leadership also provides Coastal with lower product costs and a consequently higher margin.  Perhaps even more important, leadership in specific country-markets lowers the per-unit cost of advertising, chiefly related to paying for search priority on Google.

 

One of the interesting things about the contact lens business is the inability of the contact lens manufacturers themselves to get into distribution.  Their hands are tied, in my view, by their relationship with the opticians.  If the manufacturers were to compete directly with the opticians, they would risk losing share in 85% of the market that the eye doctors control.  That is the sort of short-term pain that is difficult to stand for the manufacturers.  It is easier for Ciba Vision or Bausch & Lomb to step back and sell to both distribution channels and let the market decide this battle.

 

Figure 2:  Share Price Development

 

Coastal Contacts possesses a strong balance sheet, boasting $14 million in net cash at July 31.  This strong financial position allowed management to repurchase 18% of outstanding shares during the market mayhem of its last fiscal year.  The healthy balance sheet also supports investments required to build market share that less well-financed competitors must eschew.

 

Coastal is not your father’s internet retailer – it generates a healthy amount of cash from operations.  I estimate that Coastal will generate at least $135 million in revenue this year and produce over $5 million of free cash flow.  Growth companies rarely throw off fat cash flow streams, but by my estimate Coastal’s free cash flow yield is approaching 10%.

 

 

Danger and Opportunity

 

There are no businesses without risk and Coastal Contacts is no exception.  Aggressive US competitors are pricing very competitively in the Canadian market and may potentially win a larger share in this country.  In addition, Coastal faces an ongoing legal challenge from Canadian opticians fighting to retain their lucrative contact lens dispensary business.  While CEO Roger Hardy and his management team appear to be taking these challenges in stride, they do represent serious risks to the Coastal franchise.  Another challenge, of course is managing a multinational enterprise in a fast moving market.  Strategically it is useful to have leading market shares in New Zealand and Norway, but practically it must be somewhat more difficult.

 

Assuming Coastal can grow its free cash flow by 10% per year over the next five years, a discounted cash flow value of close to $2.00 per share appears reasonable.  Undervalued on a stand-alone basis, additional potential exists for Coastal to be acquired by one of several potential strategic buyers.  Industry leader 1-800 Contacts should be able to generate significant synergies through acquisition.  Likewise, Hamburg-based Fielmann AG, a powerhouse in European discount eyewear, could no doubt make an accretive acquisition at prices above two dollars.  Chinese players lacking Western distribution (e.g. Shanghai-based Horien Contact Lens Co.) may also be suitors for a strong, geographically diversified vendor. 

 

Traditional retailers like Costco and Wal-Mart may also be looking for entry points.  Interestingly, Wal-Mart has struck up a joint venture with 1-800 Contacts.  Surely Tesco or Aldi would entertain a play of this nature as well.

 

Management does own a sizeable chunk of stock, about 27%.  There is also a shareholders’ rights plan.  But given there are also three million options outstanding at a $1.00 average strike price, I think a serious bid of $2.50 would get pretty serious consideration to say the least.  There is just too much upside to be had in the short run.

 

Coastal Contacts is a good business.  It is arguably undervalued, growing strongly in a recession, without a controlling shareholder and surrounded by potential deep-pocketed acquirers.  I may be no Reggie Jackson, but this pitch looks worth a swing to me.

Canlan Ice Sports - Canada's Soul, 25c on Replacement Cost

If there is an embodiment of business achievement in this county, it may be Jim Balsillie.  Yet the creator of the Blackberry, showered with wealth, seems still unfulfilled in his ambition.  That he appears obsessed with acquiring an NHL hockey team can come as no surprise to most Canadians.  Becoming a billionaire is nothing to sneeze at.  But in Canada, real success stories require pucks and ice.

For this reason, it is curious to find Canlan Ice Sports trading at about one-quarter of the estimated replacement value of its 63 ice rink network.  Home to over 60,000 adult hockey nuts and used at least occasionally by most of Canada’s half million juvenile players, Canlan’s ice rinks are amongst our nation’s trophy assets.   But, tripped up by competition from civic arenas that price below full cost, and bearing a debt burden from a building spree that ended more than a decade ago, Canlan struggles for investor attention.   Weak on a net income basis, but strong in assets and free cash flow, this business appears substantially undervalued.   

                                                                                                                                                                    

Figure 1:  In Canada, Real Success Stories Require Pucks and Ice

 

 

 

   

Company Background

 

Canlan Ice Sports emerged as a focused ice rink business in the wake of a commercial real estate bust in the late 1990’s.  Its properties were carved out from a broader real estate portfolio controlled by Vancouver’s Barker family, who had been one of the early developers of the Whistler ski resort. 

The company expanded aggressively in the mid-1990’s building six multi-rink facilities in British Columbia, Ontario and Quebec.  However, the rinks never returned the anticipated profits.  With a heavy debt burden, and highly seasonal cash flows, the company required frequent bailouts from the Barkers.  Ultimately, the business has survived, but has never been an economic success. 

The main difficulty in the business model of Canlan Ice Sports is the existence of hundreds of competing community-owned rinks.  Operating on a cost recovery basis, which does not take into account the cost of arena capital, community rinks undercut the price levels which would support a reasonable return.  A recently announced $500 Million Canadian government program to upgrade recreational facilities across the country seems likely to put further pressure on Canlan.                     

 

 

Figure 2:  Stock Price Chart – Canlan Ice Sports (ICE.TO)

 

 

 

In reality, for the past fifteen years, Canlan Ice Sports has been a mechanism through which the controlling shareholders have subsidized the hockey playing public of Canada.  As a father with three hockey playing kids, I offer no complaint.  The Order of Canada has been awarded for less important public service.

Business Overview

 

Company revenues were $65 Million dollars in the recently completed fiscal year, which equates to about $1 Million per ice pad.  Seventy percent of revenue comes from ice rental with the balance resulting from restaurant sales, pro-shop and other sources.  About half of Canlan revenue comes from Ontario rinks with the rest distributed across Canada and a few American centres.

 

The company appears to be competently managed.  Costs which can be controlled appear to be so.  Canlan management have segmented their market well and built a successful offering for a middle-aged clientele.  The Adult Safe Hockey League, a well-organized city-league with referees and online statistics, provides the business with most of its ice rental revenue. 

 

With 13.3 Million shares outstanding and a $1.20 recent share price, Canlan has a miniscule $16M market cap.  Adding in $50M of mortgage debt yields an enterprise value of $66 Million.  Chief Financial Officer, Mike Gellard estimates the replacement value of owned facilities to be in the neighborhood of $250 Million.

 

Profit margins are relatively slim for a business with so much fixed asset base. Earnings before interest and taxes amounted to $7 Million in 2008.  Net income, including a $1.7 Million tax recovery was $3.8 Million, putting a trailing 4X earnings multiple on the business.

 

 

Investment Thesis – Value in Earnings and Value in Assets

 

Even given its high degree of financial leverage and risks in the broader economy, Canlan’s 4X trailing earnings multiple looks low.  However, when viewed as asset play, Canlan looks even more interesting.  With 11 multi-pad ice facilities owned freehold, Canlan Ice Sports possesses 1.2 million square feet of serviced real estate in major metropolitan centres across Canada and in the Northern US.  Were this real-estate deployed in the more mundane applications of merchandise warehousing, or refrigerated storage, on the surface it would appear to be worth considerably more. 

                                                                                                         

 

Figure 3: Comparison of Canlan Real Estate Value vs. Other Uses

	Price per Sq. Foot	Sample Transaction	Sample Price
Serviced Warehouse (Canadian Metro)	$75-150	Keuhne & Nagel            (Mississauga)	$105/sq. foot
Cold Storage Facility (Canadian Metro)	$120-180	Kingsett Capital (Calgary)	$156/sq. foot
Canlan Ice Sports Portfolio	$55 (EV at market)	Vineland Arena (NJ – option)	$57/sq. foot

Sources: Avison & Young 2008/2009, Marketdepth analysis

 

 

If we capitalize the real estate at $100 per square foot, far below its apparent value as storage space for frozen meat, enterprise value for Canlan would soar to $120 Million and the equity might be worth more than $5.00 per share.  It seems preposterous to consider converting these assets to cold storage, and no doubt in the short term such an option would be impractical.  But somehow, whether it comes in the form of ice rink condos, frozen food storage or something else, Canlan’s real estate should eventually attract a much higher valuation.

 

Another potential avenue for monetizing Canlan’s asset base may well be in the area of naming rights or sponsorships.  Canlan’s customers are a large and attractive demographic.  As participants in a nation-defining pastime famous for inspiring intense emotions, perhaps Canlan’s clientele is open to the subtle influence of brand-based advertising.  Would memories of a winning goal scored at age 11 in an Ice Sports rink last just as long if that rink were named the Tim Horton’s Centre…or the Nike Bauer IceHouse?  Highly likely, in my view.                                  

 

Figure 4: Selected Facility Naming Rights Deals

Facility	Owner	Sponsor	Value
Magna Centre (multi-purpose arena complex)	Town of Newmarket, ON	Magna International (& 6 others)	$5.6M over 10 years (2006)
WFCU Centre (arena)	City of Windsor, ON	Windsor Family Credit Union	$1.62M over 10 years
Telus Calgary Science Centre	Calgary Science Centre Society	Telus Inc.	$9M over 20 years

Source: Company websites

 

 

As Figure 4 shows, companies have paid large prices for Canadian naming rights well below the level of professional sports venues.  One suspects a valuable corporate tie-up could exist for Canlan.  The only question is whether the partner would be more interested in outright acquisition compared to a naming deal of similar dollar magnitude.

 

Summary and Target

 

Even on a status quo discounted cash flow basis, the current $16M equity value seems far too cheap for this business.  A more reasonable cash flow value might be over $50 Million or $4 per share.  See the attached simple valuation model for more detail.

 

Download Ice Sports Model

 

However, adding even $5-10 Million for untapped alternative real estate uses and $4-6 Million for a corporate sponsorship or naming rights deal would bring fair value in the $60-70 Million range or $5 per share.  Beyond this level, a much higher price might exist were Canlan to attract the attention of a less price sensitive buyer such as Mr. Balsillie.

 

On the downside, the presence of the Barker family’s 75% stake provides some hope of support for equity if operating income declines sharply due to the recession.  Having propped up the business this long, one doubts the Barkers would let their stake go to zero on a covenant breach.  With a very plausible tripling scenario and not much risk of a permanent loss of capital, Canlan presents an investment opportunity with odds stacked in favour of a worthwhile return.