Marketdepth

Morning on Howe Street

It’s morning again on Howe Street.

That’s right, Howe Street, the ancestral home of “pump and dump,” is rising again.  This time, however, it is not the push of aggressive promotion, but the powerful pull of fundamentals that is creating opportunity for our city’s most notorious industry.

Precious metals are soaring as gold and silver become re-established as monetary standards.  Base metal demand is set to expand rapidly in the large-population economies of Asia and South America.  Metal stocks are cheap compared to bullion prices.  The world economy is desperately short mine production.  These are the opportunities Howe Street exists for.

Figure 1: The Exchange Building on Howe Street – Early Days 
 

Howe Street’s resurgence, and the return of the speculative mining issue to mainstream portfolios, will create bountiful profits for some.  Others will make losses.  As we head into another potentially euphoric period for mining equities, it may help investors to recall a little history. 

Howe Street, The First Generation 

Until the mid 1960’s, the Vancouver Stock Exchange existed as a sleepy regional market, focussed largely on timber companies.  That changed with the strike in 1965 of a rich lead-zinc deposit in the Northwest Territories by the interestingly-named Pyramid Mines Ltd.  The company’s stock which, for its time, was relatively widely held across Canada, shot from 25c to $22 almost overnight. .  Ultimately the company was sold to a senior entity, Pine Point Mines, for $33 million.  [While that doesn’t sound like much, recall at the time that a Big Mac was 15c and Berkshire Hathaway stock was trading at $18.]  

The Pyramid Mines discovery started a bonanza that brought mining investors and promoters from around the world to Vancouver.  Amongst these was the inimitable Murray Pezim, formerly a Toronto-area butcher, who quickly became Howe Street’s promoter-in-chief. 

For a while, the momentum was unstoppable.  Buy orders placed in the morning showed profits by the afternoon.  Cars stopped in the middle of Howe Street as drivers rushed into the exchange building to place trades.  

Buy on Mystery, Sell on History

And there were other successes.  Carolin Mines was another 40-bagger gold discovery.  Dia Met and Diamond Fields also worked out well later on.  But unfortunately, Howe Street’s reputation was made mostly by the scam artists who preyed on the gullible in the decades following the Pyramid Mines success. 

The schemes were often “close-ology” plays, with promoters staking nearby tracts to large discoveries.  “Wash trades” within a close circle of insiders would drive up prices steeply in advance of the release of bogus drilling results.  Hapless investors would buy in at the peak, only to watch share values plummet.  Insiders profited from outsiders.  It was the Vancouver way. 

But by the 1980’s the inflationary fundamentals that had underpinned Howe Street’s rise went into reverse.  In the era of 20% interest rates, bonds and blue chips were far better values than $800 gold bullion or junior gold speculations.  The Dow Jones Industrials grew by more than 10x from 1982 to 1999, while the VSE Composite index tanked.  Initiated at 1000 pts in 1982, the VSE Composite closed in October 1999 at 395. 

And in 1999, just as bottom of the gold cycle was being reached, Howe Street’s exchange was disbanded and merged into the CDNX.  Ironically, the end of the VSE marked the point of extreme fundamental undervaluation of this city’s mining juniors.  Alas, by 1999 those who understood the fundamentals were so discredited that no one would listen.  Buy on mystery, sell on history. The strategy of the know-nothing retail investor was ultimately applied to the VSE itself. 

What to do now

In the last ten years mining stocks have recovered and the safe money has been made.  However, my read of this cycle is that a speculative blow-off phase lies ahead.  The gold market didn’t spend 20 years bumping along around $350 per ounce to stop at a mere quadrupling, in my view.  

Likewise junior mining stocks that can deliver reserve growth breakthroughs appear to be very fertile territory.  I spend time these days looking at the tier of juniors just below the size of companies that are eligible for the exchange-traded funds.  Within this class, companies with capable management teams and decent properties should be the basis of a portfolio that can properly capitalize on the return of Howe Street.  

I’m doing my own digging into junior miners with potential, but if any of the esteemed readers of this blog have particular names they think I should investigate or avoid I’m all ears.   

 

Vecima Networks - Liquidation Value with Growth Potential

The stock market, presented on paper as mere columns of names and prices, is not fairly characterized.  In reality, the market is a huge wheel which rotates to pull stocks from the depths of obscurity to a pinnacle of overvaluation and back down again.  Looking at companies currently riding the bottom of the wheel, one finds Victoria-based Vecima Networks (TSX: VCM), a next-generation industrial company trading at a buggy whip price.

 Figure 1:  Vecima –  Rotating Downwards, then Turning Up?

 

 About Vecima

Vecima Networks, founded in 1988 by engineering professor Dr. Surinder Kumar is in the business of creating devices that manage and transfer high volume data flows, the likes of which are found in cable networks, wireless communications systems and other similar applications. 

The company’s products bridge the final network segment that connects a system directly to end-users, commonly referred to as “the last mile”, where Vecima’s special capabilities in radio frequency are employed.  Key applications of Vecima’s technology include DOCSIS standard wireless broadband services and “QAM” (quadrature amplitude modification) that allows the simultaneous provision of video, voice and data services.  Vecima’s customers include major cable operators such as Comcast Corp (Nasdaq: CMCSA) as well as large network original equipment manufacturers like Cisco Systems (Nasdaq: CSCO) with whom the company has enjoyed a productive fifteen-year relationship. 

In addition, the company operates a nascent wireless data network operator called YourLink in Western Canada.  It also acquired Burnaby-based Spectrum Signal processing in 2007 for approximately $20 million. 

Vecima had revenues of $113 million in the year ending June 30, and profits of $0.8 million.  The annual profit represented more than a 90% decline from FY 2009 net income of $13.2 million.  Share prices have followed the decline in operating performance, dropping from $7.50/share earlier in 2010 to a recent all-time low south of $4.00. 

 

Figure 2:  Vecima Networks Stock Chart 

 
Challenges and Opportunities

Vecima’s troubles in 2010 appear to have stemmed from factors both within and beyond the company’s control.  External factors include softer than expected end-demand in the US cable market, which has led to somewhat reduced capital spending by larger operators.

Controllable factors may also have contributed.  In particular, the company’s large number of small-scale market initiatives may have diluted Vecima’s competitive positioning in key areas.  For example, there appears to be little overlap between the business of supplying capital equipment to cable operators and running YourLink, which is essentially a retail operation.  Yet these and other disparate businesses compete for management’s time and corporate resources.

To management’s credit, the project of re-focussing Vecima appears to be underway.  The company has recently centralized some distributed R&D activities and more moves of this nature could be in store.  Likewise, on the marketing front, Vecima is making a concerted push into a niche opportunity related to hotel HDTV networks.  This initiative, being pursued directly as well as through a large OEM partner, addresses a market estimated at $450 million without significant established competition. 

Valuation and Risks

While Vecima’s business is a little complicated, the valuation is easy.  This is a cheap stock.  Very solid net working capital is $48 million, property and plant (at a 50% haircut) adds $17 million, and wireless spectrum assets (based on recent transaction values) are worth a further $38 million.  Net of debts, a liquidated Vecima is worth at least $100 million, or 10% more than the company’s quoted market capitalization.  Beyond liquidation, if one believes that Vecima can recover even half of its historic levels of profitability, then an $8 share price would be well supported. 

Due to a controlling stake held by Dr Kumar, Vecima is not a takeover candidate.  However, at these levels a take-private bid would not be out of the question. 

My main concerns with Vecima are more macro-economic in nature.  The growth push into hotel HDTV networks occurs at a weak moment for hotel operators, who face continuing revenue challenges that have been further compounded by the bedbug scare.  However, if we wait for the robins, spring will be over.  Although we may not be at the absolute bottom for Vecima, I believe we are close enough to be confident of a solid return from current levels.

 

Westport Innovations - Lighting a Single Candle

Here at Marketdepth, we are not in the business of selling equities to the public.  In fact, our focus is often on the somewhat less glamorous activity of preserving capital.   However, being of a generally curious disposition, from time to time we do a bit of digging on one of the local companies of our acquaintance.  Small cap management in town is generally rather approachable and we enjoy hearing them out.  When the time to buy advantageously comes along we know how to hit a bid.  But every company knows a lot of other times.  

 

It is in this spirit that I review Vancouver-based engine technology business, Westport Innovations Inc. (TSX:WPT).   Recession notwithstanding, the company still grew sales by 9% and its gross margin dollar line expanded by 28% in calendar year 2009.  While not cheap on a ratio basis, I consider Westport one of the more promising looking “acorns” in its class and worthy of longer-term consideration.  Better to light this single candle of background research than curse the prevailing darkness of overvaluation.

 

Figure 1:  Better to Light a Single Candle…

 

 

 

 

Background

 

Westport began operations in 1995 with the intent of commercializing a natural-gas fuel injection technology that resulted from research led by UBC engineering professor, Phil Hill.  Under the direction of CEO David Demers, Westport has since become the world’s leading technological solutions provider to developers of heavy duty engines that run on natural gas.

 

The principal current installations of these engines are municipal service vehicles like buses and garbage trucks.  However, there is clearly potential to expand the penetration of Westport’s technology into commercial trucks and, ultimately, into any type of engine that currently runs on diesel or gasoline.

 

Westport’s business model more closely resembles that of an outsourced R&D group rather than a fully-fledged manufacturing business.  In fact the company has largely gone to market through product-specific joint venture arrangements with established engine makers.  The most significant of these relationships at the moment is Cummins-Westport Inc., a 50-50 joint venture that accounted for the lion’s share of Westport’s revenues in 2009.  Recent deals with several international partners including Volvo and China-based Weichi Power Co. may establish a path towards a broader product mix and a more diversified customer base over the next three to five years.

 

Investment drivers

 

From an investment standpoint, it is useful to consider two important, and separate, underlying drivers of demand for Westport’s engine technology.  The first driver is the global demand for heavy engines.  Heavy engine demand has taken a hit over the past year or so due to weak economies.  I have no special insight into when that demand might recover, but flag here that Westport’s success is dependent on this variable.

 

The second key driver of demand for Westport’s product relates to penetration of the transportation energy market that can be achieved by natural gas engines.  And the critical factor here is the long-term development of the ratio between natural gas and oil prices.

 

Figure 2:  Oil to Gas Ratio

 

 

 

 

On a pure energy equivalent basis, the ratio between the value of a barrel of oil and a thousand cubic feet of gas (mcf) should be 6 to 1.  However, with current market prices of about $80/barrel of oil and $4/mcf for gas the actual price ratio is 20 to 1.  In other words, the market is paying more than three times the price it “should” pay for petroleum products relative to the price of gas or liquefied natural gas (LNG).  Why the discrepancy?  Clearly gas is in a glut situation, driven by large new discoveries and improved extraction techniques.  On the other hand oil markets are facing dwindling conventional production combined with a growing base of transportation equipment designed to run on petroleum-based fuels. 

 

The other factor weighing against gas at the moment is that the market lacks the necessary infrastructure (pipelines, distribution networks, marketing organizations etc.) which are required to realize the pure chemical arbitrage.  However, I believe it reasonable to expect that the long-run oil-to-gas price relationship will converge towards the energy equivalence ratio of 6 to 1.  And, given that prospective trend, underlying demand fundamentals appear generally supportive of Westport’s product offering. 

 

Entry Point

 

With a recent enterprise value of about $450 million, Westport Innovations is somewhat bigger than your typical acorn.  And trading at 4X consolidated sales, it is difficult to construct a classic value case here.  Simply put, this company needs to grow rapidly in order to justify its valuation.

 

I tend to agree with management that the prospects for Westport are good in the long-run, but also flinch a little at the current sticker price.  However, 2010 could easily deliver bad news on the global truck market or a see a temporary collapse in the oil-to-gas price ratio.  Ideally, we might get both situations going wrong at once.  At such time, no doubt the chorus of boosters for Westport may be somewhat thinned out.  But that would be a wonderful entry point on Westport Innovations, a business with a fundamentally strong story with great potential for future growth.