First off, this is a longer post than usual, I am trying to get some more detailed work on the website to show my thought process to prospective employers, instead of just venting my frustrations! I am looking to join a new value investing firm, any help from you guys would be appreciated, email me at [email protected], or tweet @hardcorevalue for more information. I have 2 years experience with a very well respected value firm as an Analyst and have completed the CFA exams. I’m Canadian but available to move anywhere (I love traveling and learning new languages) and can start on working holiday/tourist visa. Traditionally, I seek to identify undervalued business that have competitive advantages and compound money at high rates of return with low risk of capital impairment but I also enjoy Ben Graham or special situation stocks, which is the one below. Let me know your thoughts, or if you have anymore research please contact me.
After writing last week’s article on coat-tailing and Danier Leather, I took another look at ABC’s Value Favourites page and came across Bennett Environmental, it trades for $2 on the TSX, has $1.60 in cash per share, few liabilities and produced .60 cents in cash flow per share last year. The company remediates contaminated soil and contaminated construction debris. The business is extremely ‘lumpy’ and revenues are not diversified as 99% of revenue was from 1 government contract in 2010. For the facility to run efficiently significant amounts of man power and butane and propane are needed. Therefore the plant is most efficient when running 24 hours a days for as long as possible. Since demand is sporadic, the plant is often shut down and and inventories of contaminated soil are stockpiled at its Quebec facility. The plant was operating about 75% of the year in 2009 and 2010 producing 42 and 56 cents per share (unadjusted). Barriers to entry are present due to the high cost and difficulty of permitting, although alternative technologies are available at varying degrees of effectiveness. However, the two biggest contracts in the last 2 years in Ontario both went to Bennett.
Bennett has an ugly past. Results are a fraction of historical levels, in part due to the substantial conclusion of the US Superfund program which provided funds for site remediation. Also its previous management pleaded guilty to participating in a conspiracy to defraud the US Environmental Protection Agency (EPA) over the period 2002-2004. Bennett received a $1m criminal fine. In 2007, with the company facing solvency concerns, Second City Capital Partners participated in a rights offering for 5.4m shares at 75 cents with 1.08 million warrants exercisable between 77 and 87 cents, expiring in 3 years. By 2011, with profitable operations restored, a large battle for control of the company and its massive $1.60 per share cash hoard took place.
Second City Capital is a private equity firm based in Vancouver and Bennett’s largest shareholder at 23%. Second City thought management was taking too long to put Bennett’s cash to work. Also, Second City alleged self-serving and related party transactions. Finally, Bennett had entered into a very strange stock option backstopping guarantee scheme that transferred the price risk from the board to shareholders. Second City’s plan was favoured by Irwin Michael and his 18% ownership voted in favour of replacing the board.
The drama climaxed shortly before the vote was to take place when Bennett proposed a special cash dividend to shareholders, a last stand to appease shareholders and very contrary to Bennett’s long standing approach of using the cash for an acquisition. In my opinion as a value investor, this would have been a good, low risk outcome. However, Second City had bigger plans for the cash and went to court to ensure the dividend did not get declared. The dividend never came and a truce was formed between Second City and Bennett. A new CEO was to be installed and 4 of the 5 directors replaced with Second City nominees (Second City already had a director on the board from years before, Jamie Farrar.)
Here’s what’s happened since Second City gained control this summer. Revenue has gone to zero, this isn’t great but should be expected from time to time given the operations model of stockpiling. So far net income for the 9 month period is negative $5.5m pre-tax (14 cents per share) when excluding the board restructuring costs. No acquisitions have taken place and new management is clear that no dividends will be declared. Operations will only start again ‘in the first quarter of calender year 2012’ so look for full year earnings to be weak. Also, the interim CEO and Chairman, Lawrence Haber, is now the permanent CEO and Chairman.
After getting up to speed. There are some major questions that need to be answered.
First: Why is Bennett not extremely busy? A Canadian government regulation required that PCBs in storage must be shipped for destruction by the end of 2009 or alternatively, the owners must treat the stored material onsite within two years (less than two months from now)
Second: What will happen with the cash now that Second City is in control?
Let’s deal with the cash first. It’s very likely to be used for an acquisition, my biggest fear is it will be a related portfolio company to Second City. It would have to go to a shareholder vote but it is a big concern. As part of its proxy battle, Second City detailed their prior discussion on a major investment. In early 2010, Second City offered Bennett a deal in an infrastructure company called Rockford. It didn’t go through but was acquired by another company at a higher price. Rockford is profitable and all of the earn-outs have been achieved prior to the deadline. It appears as though the Second City deal would have been quite satisfactory for Bennett shareholders. There have been no acquisitions since, but Bennett’s new management continues to look (not just in the environmental industry) and they have the incentive to put the money to work.To determine why Bennett is not busier we have to look at the PCB market which is the main type of substance remediated by Bennet. PCB stands for Polychlorinated Biphenyls. They were first manufactured in 1929 for use in industrial materials, however PCBs are very difficult to break down (which is why they were so useful in finished goods) and are often found in the surrounding wildlife, particularly the surrounding soil and great lakes (and their fish). They were banned 30 years ago and began accumulating in PCB storage sites across the country (mainly in Ontario). PCBs are not allowed to be imported or exported across the border with the US, so their destruction is entirely a Canadian issue.
From talking to government representatives and industry insiders there appears to be two types of PCB numbers. The official numbers and real numbers. The real numbers are extremely difficult to estimate because PCBs can spread so easily and aren’t noticeable. I’ve talked to a number of insiders, and no one has any idea what the number is, just a general sense there are lots of PCBs remaining. One insider thought that there are over 20 sites far exceeding 20,000 tonnes per site of PCB contaminated soil and I have no reason to doubt that.
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Officially, the number of PCBs has been greatly reduced. Ontario has taken great strides to comply with the Federal deadline. The Pottersburg PCB dump site was recently closed. Pottersburg was a massive 113,000 ton facility and by far the biggest PCB dumpsite. The second biggest PCB dumpsite is surprisingly in Toronto, at 22,000 tonnes and is in the process of closing down. I obtained figures from the Ministry listing the number of PCB dumpsites both public and private in Ontario.
Number of PCB Waste Storage Sites
So in the last 7 years the number of PCB sites have been reduced by a massive 75%. However what is even more alarming for Bennett is Ontario’s official PCB numbers: Only ‘32,000 tonnes of soil and gravel’. And this was clarified that it still includes Schneider dump site numbers. Schneider has 22,000 tonnes that are being re-mediated. Therefore, officially there are only 10,000 tonnes of PCBs left in Ontario sites. This is bad news for Bennett, which has an annual capacity of 100,000 tonnes of PCB destruction. Although there may be hundreds of thousand of tonnes of PCB contaminated soil in Canada, officially most of it has been destroyed. And given the extreme cost of remediating soil, the official numbers are far more important. Perhaps there are many recently registered PCBs outside of Ontario, or the representative I spoke to had the wrong figures (although I made sure it was confirmed.) Nevertheless a report from Environment Canada on the national PCB database is due at the end of the year and will will clarify the figures from 2008-2011.
Looking at the recent contracts from Bennett confirms the importance of the official database, Although Bennett won both of Ontario’s largest contracts recently, the Pottersburg contract was the vast majority of their revenue for the past two years. The company could have taken on other remediation work (non-PCB), but didn’t and the plant was voluntarily closed for one quarter of the year due to weak demand. This weak non-PCB demand was one of the reasons their New Brunswick facillity was closed after massive impairment charges. Now that Ontario’s official PCB database is only 10,000 tonnes and the Federal deadline is about to pass. I don’t see much profitability after the Schneider contract for Bennett. At $2 today and with $1.25 in cash per share less all liabilities you are not paying much for the operations, but at $6m per year in overhead and the near removal of all official PCBs, I am not buying.
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