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MFC Industrial (MIL): Ugly and uglier!

April 3, 2012

Michael Smith what’s going on? It’s not enough to say that the results of last year are unacceptable! I hope you have a plan… and I wish you’d be a little more forthcoming about communicating that plan to us formerly patient shareholders. Shares in your company are trading well under book value and have for the past year. To top it off, you make us work to understand just how ugly the 4th quarter was; you might have at least provided us with 4th quarter numbers rather than forcing us to back out the first three from the full year! Let me tell it to you straight; we investors don’t appreciate this kind of condescension! If you have a bad quarter just spit it out and let us digest it. Don’t try to hide it using a cutesy little format. We know you’re better than that!

OK. So now I’m through with the vituperation. Let’s look at what happened at MFC last year. Net income for the year was $.19 a share vs. $.86 in 2010 (not apples-to-apples because the acquisition of Mass Financial by Terra Nova took place in the 3rd Quarter of 2010; different businesses, different share count, one-time impact of Mass acquisition, etc.). If we back out the impact of one-time non-cash expenses of $.35 a share we are still left with operating earnings of only $.54 a share in 2011. As the company noted in the press release, this was only a 6.2% return on capital, which they called unacceptable (and I concur). It’s quite hard to analyze the earnings at MFC primarily because it’s not easy to understand exactly how MFC earns money in the first place. The description in the annual report is anything but transparent.They define 3 lines of business; ‘commodities and resources’ which generates the bulk of the revenues, 93% last year, and ‘investment banking’, which, together with ‘other’ (royalty income, I assume), made up the remaining 7%. The company defines itself as a ‘global supply chain company’, whatever that is. I tend to define them as a commodity broker with a small investment banking effort and royalty revenue stream. My problem is that I have no idea what level of risk is involved in the brokering. Is it more like an arbitrage, where they have a buyer before they commit to purchase, or is it more speculative, i.e. they are committing to the purchase of the commodity before they secure a buyer? Therein lies the conundrum of what return on capital is acceptable. In the first case perhaps 15% might be acceptable for an almost riskless transaction. If it’s speculation they’re engaged in, then 25% would be an insufficient return.

I had anticipated that in 2011 MFC would deploy its existing capital to acquire additional royalty streams or resource properties. The purchase of the Pea Ridge iron ore mine was a step in that direction. However, it was a rather small step ($12 million invested last year, though it is unclear what future capital investments will be required for the mine to become operational). In any case, it looks like the project will not generate returns for the next 2 to 4 years. I don’t find this consistent with increasing the company’s return on invested capital in the short run.

The announced divestiture of $100 million in assets and return of capital to shareholders has now been put on permanent hold. I’m a bit peeved that they announced the divestiture last Fall before they had a firm plan, and then had to backtrack. Why would they do this? Perhaps they were not able to finalize a tax efficient way of returning the assets to shareholders. Perhaps they realized they might need additional capital, as they state in the press release.  Perhaps the assets they had targeted to liquidate didn’t have the value they anticipated. Perhaps there is another reason. In any case I now find myself with an oversized position, which I will likely reduce shortly. This whole story leaves me with somewhat less faith in the pronouncements of management.

Then, there is the question of the announced odd lot tender offer in early April. I’m not quite sure what the purpose is. Do they have that many small shareholders? In any case, it seems rather insignificant in the scheme of things, yet it a was announced with great fanfare. Why? Unfortunately my conclusion is that they didn’t have much else to announce, and that’s a bit unfortunate.

Lastly, lets look at the one-time expenses. There was a $6 million non-cash expense associated with management incentives. This was a first quarter expense associated with the corporate reorganization of 2010, but in retrospect, not very timely when juxtaposed with 2011 results. Then there was the $11 million write-down of securities described as “an other-than-temporary impairment charge on our strategic long-term investments”. Could we be a little more specific please?

Let’s move over to the balance sheet. Shareholder equity was down slightly year over year; Net income plus share-based compensation was more than offset by dividend payments and the write-down of available-for-sale securities. Well, all I can say is that if the decrease continues for long enough, the return on invested capital might just increase to an acceptable level! (didn’t I say before, enough vituperation… shame on me!)

Now on to the cash flow statement. Cash balances decreased about $10.6 million year over year. This was slightly less than the dividend of $12.5 million, so everything else netted out to a $2 million increase; the $44 million of cash flow from operations was used for 1) purchase of long-term investments ($30 million net), 2) increase in loan receivables ($14 million net), 3) debt repayment ($4.3 million), offset by distributions from subsidiaries ($5 million). What was the $30 million of net long-term investment? Twelve million dollars was the Pea Ridge Mine. The balance of $25 million (less $7 million in sale of long-term investments) appears to be accounted for by investments in:

  • Thayer Land Development (50%)
  • TTTT Mining (50%)
  • Upland Wings (50%)
  • Wings Enterprises (50%)

What these are might be interesting to know… but we’re not allowed much more insight than a line item in the notes. Unless I’m missing other investments (which I really could be as things aren’t so clear in the annual report), these 4 investments have an imputed value of $50 million, not inconsequential when compared to MFC with its market capitalization of $500 million. A little bit more disclosure perhaps?

In sum, overall nothing terrible come out of MFC’s 2011 annual report. It’s just that nothing particularly good can be therein gleaned either. The fourth quarter of 2011 was not particularly pretty, and we’ve been given no clues that perhaps better things are right around the corner. You have to know that you need perseverance to hold any of Michael Smith’s companies; we’ve learned that through the corporate gyrations that have taken place over the past couple of years. In the past, however, holders have been rewarded. But it’s also clear that the time to invest in these companies are those are moments when Mr. Market is not particularly understanding. MFC has been pretty beat up over the past year so maybe we are at such a moment now. Unfortunately I have better no window into what’s happening at MFC than what is presented in the annual report.

The upshot, for me at least, is that I will be reducing my position slightly over the coming days or weeks to compensate for the cancelled asset divestiture. I’ll be remaining a long-term shareholder, however, because the large cash balances at MFC represent a good margin of safety.

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7 Comments
  1. GlennC permalink

    Even if the commodities business was involved in “arbitrage”, they would be involved in the risky type of arbitrage. They are presumably taking on counterparty/credit risk and/or hedging risks (with most forms of hedging, you trade one set of risks for another set of risks). If they hedge in the futures market, they are hedged for physical delivery to a specific location which is almost certainly not the same location as their cusomter’s location. And they are likely dealing with different grades/quality of product. I presume that MFC is taking on such risks (as well as other risks).

    The business is exposed to fat tail events… so they lost a lot of money in 2008. Therefore a 6% return on equity in good times is unacceptable.

    The commodities business started out as Hovis Trading, which was acquired several years ago by MFC. It’s never been a great business, but Michael Smith has let it use MFC’s cash reserves to generate a very modiocre return on that capital.

    The Wabush iron royalty is a very significant asset (definitely worth >200M), especially if Cliff’s intends on expanding production. (But Cliff’s will probably overestimate production because that’s what many mining companies do.) I am guessing that there is little discussion on it because Michael Smith is trying to figure out how to spin it off and how to get people to misunderstand its value. He has done these silly spinoff shenanigans twice in the past.

    • GlennC permalink

      I guess what I wanted to say about the commodities business (formerly Hovis trading) is that it was never a great business and still isn’t. On the other hand it isn’t a terrible business. But people who think that Michael Smith is an excellent allocator of capital are sorely mistaken. He could have deployed cash into areas with high rates of return but instead he put that into the mediocre commodities trading business.

      The iron ore royalty should be split out into its own category. It will not lose money, unlike the commodities trading. It is a very different business exposed to a completely different set of risks (production risks, iron ore prices, the mine operator underpaying the royalty). To help investors understand its value, investors need to know the mine life of the Wabush property. There has been little transparency in that department. (Though I think the mine life is very very long. If it wasn’t, Cliff’s wouldn’t talk about a mine expansion)

  2. Amanaman permalink

    Thayer Land Development, TTTT Mining, Upland Wings and Wings Enterprises are all part of the construct that was used to take over Pea Ridge.
    Fully agree on all your other points.
    This is a non-public company that wants to make believe it is public. I have a hard time understanding why the management is consistently working AGAINST the shareholders which is supposed to work for, by not disclosing the most essential things.
    GlennC: what do you think of the fact that Hovis, after selling his business to MS, has essentially re-built the same business under a different name? (http://www.carbones.at)

    • GlennC permalink

      I didn’t realize that Hovis rebuilt his business. I suppose that you cannot own/buy people. I don’t think that Jurriann Hovis can be faulted for working in a business that he has experience in.

      Perhaps Michael Smith will try to thoroughly confuse investors and get them to sell shares too cheap while the company is buying back shares, similar to what John Malone does. (Although Malone did not do anything as egregrious as the rights offering that KHD did where retail investors were not allowed to participate.)

    • This business (carbones.at) is coal principally.. they maybe had a deal to split coal trading from the steel and ferro-alloys..

  3. PPP permalink

    What is clear after listening to Smith over the past several quarters is, precisely, that he does NOT have a plan. One minute he is focussed on building the low-capital-intensity “supply chain” business, the next he is committing capital to re-opening a mothballed iron ore mine. One minute he is misguidedly complaining about the high non-cash depletion charges associated with his iron ore royalty (remember that from a few quarters ago???), the next he is rescinding a promise to return capital back to shareholders (the intended amount started high, went higher, then went to nothing, presumably because of the Pea Ridge investment). One minute he is suggesting big earnings numbers for the second half of 2011, the next he is doing everthing to camouflage Q4/11 results. One minute he institutes a dividend policy that is at first based on a market value yield, until his largest shareholder rightly suggests on a conference call that a more logical basis would be book value, to which he agrees, only to subsequently update the policy based on market value (again).

    I own the stock. I am getting frustrated and tired with value investing platitudes from this management group, without any apparent coherence to their strategy. Don’t get me wrong, we ALL want to be Warren Buffet.

    My suggestions: 1)Give us better information, and FACTS; we are grown-ups and can make our own assessments, 2)Stop thinking out loud on conference calls, unless it’s a done deal, 3) If you have nothing to invest in, then give us back our money, 3) Don’t think for a minute that we are not watching you closely, and 4) If you want a premium to book value, then EARN it.

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