KHD Humboldt Wedag International/Terra Nova Royalty Corporation
This post has been a while in the making and I have had to update it several times as information has trickled down from mangement. We’re close to the final juncture now, with the rights issue and third phase of the stock spinoff less than a month away. The true value of these two companies should begin to emerge in 6 months to a year (if we’re lucky) once the dust settles.
The company that was KHD Humboldt Wedag International until March 30, 2010 (old KHD) is in the middle of a corporate reorganization which is somewhat difficult to follow. Certainly, the stock price has suffered over the past several years, though this can be attributed primarily to the fallout from the 2008/2009 world financial crisis. However, I do think a number of factors have conspired to create an opportunity.
Old KHD has a history of corporate transformations. Michael Smith, the Chairman, seems to have a penchant for complex companies and reorganizations. You can read the history of KHD and its predecessors in an old annual report as it is too long and convoluted to reproduce here. Prior to the corporate action in March of this year the company had worldwide operations, was headquartered in Canada and its shares were listed on the New York Stock exchange under the symbol KHD. Between 2005 and 2009 its shares traded between $6.75 and $44; shares traded around $10 at the beginning of 2005, climbed to a high of $44 in 2007 before falling during the market rout of 2008/2009 to $6.75 then recovering to around $14 at the end of March 2010.
On January 6, 2010 the company announced that, subject to shareholder approval, it intended to restructure itself into two distinct legal entities through the distribution to shareholders of all the common shares of its industrial plant technology, equipment and service company, KHD Humboldt Wedag (Deutschland) AG (“KID”). After the distribution, the remaining company, renamed Terra Nova Royalty Corp. (TTT), would hold all of old KHD’s mineral rights and cash. Management determined that “the most fiscally responsible way for KHD and its shareholders to effect the distribution of the KID shares [was] in several tranches… [in order to]…minimize the tax impact to [the company] and its shareholders.”
Shareholders voted on and approved the plan to split the company on March 29, 2010. The initial steps of the reorganization process were laid out in a March press release:
“First Tranche Summary and Time Line:
- Shareholders will receive one (1) KID share for every three and half (3½) KHD shares (calculated after a 2 for 1 forward split, subject to KID shareholder approval).
- Additional distributions of KID shares expected by the end of the year.
- Initial percentage of KID shares distributed: 26%
- Shareholders meeting date for approval March 29, 2010
- Ex-dividend date March 30, 2010
- Distribution date of shares March 31, 2010
- Listing date for KID shares on the Frankfurt Stock Exchange: March 31, 2010, symbol KWG.F
To obtain greater liquidity and shareholder awareness for the KID shares, KID will offer a placement of 10% of its shares in Europe. To assist US citizens to trade the KID shares, KHD is planning on establishing a level 1 American Deposit Receipts (ADR) program in the United States.”
What’s interesting here is that 1) the majority of old KHD’s revenue and profit was generated by the industrial plant technology, equipment and service company, KID, 2) KID was the company that was being ‘spun off’ not the much smaller mineral rights company, 3) KID was being listed exclusively on the Frankfurt exchange with some hope for US holders that there would be an ADR, and 4) the company clearly stated that it would make no statement about the tax implications to US investors. Hmmm, interesting. Someone wasn’t making this look very attractive for US holders of old KHD. And that piqued my interest.
Interestingly, the pre-spin shares of KHD closed at $14.05 on March 30, 2010, traded up into the high $14’s in April after the spin, before trading down to the low $9’s in early June for a loss of almost 40%.
By mid May details of the next phases of the spinoff were announced:
Phase 2: June 30 – distribution of an additional 23% of KID (KHDHF shares) to holders of TTT shares on a 1 for 4 basis. It was announced this would be a taxable spin-off for US shareholders, and Canada would impose a withholding (15% for US residents, potentially more for residents of other countries)
Rights issue of TTT: no date or details given, but based on the share count provided for the phase 3 spinoff of KID shares it could be assumed that rights will be issued on a 1:4 basis, 1 right for each 4 shares of TTT held, each right allowing the holder to purchase 1 additional share of TTT at some to-be-determined discount.
Phase 3: August 30 – distribution of an additional 29% of KID (KHDHF shares) to holders of TTT shares on the record date on a 1 for 4 basis.
Phase 4: no date given for spin-off of remaining 19% of KID; “[these shares] will be retained by Terra Nova until the bank guarantees issued by Terra Nova (prior to the spin-off), on behalf of KID, expire in the normal course of business.”
Interestingly, when you add up the percentages that management quotes (26% plus 23% plus 29% plus 19% = 97%) do not add up to 100%; at least 1.5% of outstanding KID shares were trading on the Frankfurt exchange before the spinoff was effected, the rest may be rounding error.
Rights issue announcement
In late July details of the TTT rights issue were made public. Shareholders of TTT as of August 6 received on August 15th 1 right for each share of TTT owned. Exercise of 4 rights entitles the holder to purchase 1 share of TTT at $6.60. Rightsholders may exercise their rights until September 2, 2010. There are oversubscription rights, with the specifics on awarding the rights set out in the July 26 rights circular.
Second Quarter Earnings announcement
On August 13th 2nd quarter earnings were announced and everyone who was hoping for some clarity about financial performance of the mineral rights business was sorely disappointed. Results, a loss of $.01 per share, were again confused by costs associated with the original and subsequent spinoff of KID shares. Hmm… interesting that management showed little interest in providing clarification before the rights offering was consummated. In this regard I went searching for any tidbit about whether Peter Kellogg (a 20% holder of TTT shares) intended to exercise his rights and found a little paragraph buried in the rights document stating something to the effect that TTT management had tried to contact Mr. Kellogg regarding this issue but were unsuccessful.
My conclusion to all of this is that management is making the rights offering look rather unappealing (despite the large discount to market of the rights exercise price). Thus, my first reaction is that I should be exercising all my TTT rights and requesting substantial oversubscription rights, but let’s look at valuation to get a better handle on whether it is really worthwhile.
OK. All this information doesn’t get us any closer to putting a value on TTT or KID (the ADRs KHDHF). TTT’s current value is still largely dependent on KIDs value, since as of August 2010 TTT still holds 48% of KID shares, so let’s start there.
Let’s start by looking at some key statistics of old KHD in 2009.
KHD 2009 (US GAAP)
Revenues $576.4 mil
Net Income $37.7 mil
Net income/share $1.24
Book value/share $10.32
Shares outstanding 30.4 mil
So how much of the revenue and net income from the combined company came from the mineral royalty business in 2009? Very little: $13.5 million in revenue and possibly up to $4.5 million in net income. It seems to me that the real issue, then, is how will the industrial business do and what value does it have? In the first quarter of 2010 revenue for the industrial business, KID, adjusting for the divested coal and minerals business, was about equal to 2009 levels, $100 million, while operating earnings were higher, $10 million vs. a loss in 2009. This is a highly lumpy business, with operating results varying substantially, quarter to quarter. The industrial business is driven by bookings and backlog, which plummeted during 2009, but seem to have bottomed out in Q4, 2009. If the sustainable level of profits from KID was, say, 2/3 the level of 2009, or $0.73 per share, at its July 1 closing price of $5.35 KID shares (KHDHF) were selling at about 7x earnings. Not unreasonable. And if the business can be built back up to 2007 earnings levels, $1.42 per share (yes, that included the coal and minerals operations which have since been sold) and we ascribed a 10x multiple we might be looking at over $14.00 a share in market value, not a bad potential upside. Furthermore, remember that this stock, almost entirely on earnings from the industrial business, traded as high as $40 a share. To me, shares of KID (KHDHF) look attractive at current levels. In fact I purchased some additional shares at the end of June for $4.95 per share. However, I don’t foresee any revaluation of the share price until this whole restructuring is over and earnings prospects become a bit clearer. There is still a significant overhang of stock that has been or will be spun off. I think quite a few of the smaller investors will bail out at the bottom on this one.
So where does that leave the value of TTT? Well, I feel pretty good about the KID component of TTT’s value. What else is there?
Components (per share)
Cash at TTT (at 6/30/10) 2.35
Securities (at 6/30/10) .45
Other current assets .54
BV of mineral rights (pre-revaluation) .86
Other non-current assets .09
KID ownership (at book after 6/30 dist) $2.63
Shares were trading somewhat higher than this $6.92 book value in July, more in the $7.75 to $8.60 range. Perhaps this was due to 2 factors: 1) the June announcement that the company would be adopting International Financial Reporting Standards and thus would be revaluing the mineral rights up by an additional $3.10 net per share, bringing the total ‘value’ of TTT more into the $10.00 per share range and 2) the KID interest was carried on the TTT books at about $5.03 per KHDH share while the shares where trading at between $5.50 and $6.00. I’m a bit skeptical of the mineral asset revaluation; I didn’t find the explanation in any of the company literature to be very convincing, but the proof is in the pudding – gotta watch those cash flows.
Then, there will be the impact of the rights issue on cash and on shares outstanding. Post rights offering the valuation of TTT per share should look more like the following:
|Components (per share)||Pre||Post|
|Adjusted Cash at TTT (at 6/30/10 + rts)||$3.25||$3.25|
|Securities (at 6/30/10)||$0.36||$0.36|
|Other current assets||$0.38||$0.38|
|BV of mineral rights (pre revaluation)||$0.69||$0.69|
|Other non-current assets||$0.07||$0.07|
|KID ownership (at book)||$2.10||$0.83|
For my own purposes I’m calculating the value of TTT as $6.85 plus the 15-20% difference between book and market for KHDHF shares, so something like $7.16 to $7.27 per share pre 3rd tranche distribution. So although I will be exercising my options (and oversubscribing as well), I will be considering selling my TTT shares in a couple of months if they trade back up into the $8.00 range. The future of TTT is too dependent on execution by a management team that, to my mind, has little track record in the mineral rights area. Furthermore, the company has announced that it will be paying a dividend at a yet-to-be specified rate, which leads me to fear that the shares could trade based on the dividend yield, yet I think shareholders are going to be quite disappointed in the initial yield based on the cash I currently see being generated by the one asset TTT owns. On the other hand, I think KHDHF has the potential to trade significantly higher based on my back-of-the-envelope analysis above, so I am counting on holding them as a long-term value investment.
I will be paying particular attention to what Peter Kellogg does in all of this; besides being a major shareholder (20%) he has significant experience in the mining and minerals area.
All in all I am a bit disappointed in management. They have succeeded in returning little value (as yet!) to shareholders with this corporate reorganization. At the end of 2009 a share of KHD was trading at $13.61. Today (8/23/10), adding up the components, an investor now has a value of $10.25 (1 TTT share at $7.21, rights worth $.17 and .498 KHDHF shares – assuming you pay no more than the 15% Canadian withholding tax on the June 30 KID share distribution – worth $2.87) for a loss of about 25%.