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March 05, 2012 – Comments (7)

*This is similar to a recent post I made, but with a small tweak to my base case valuation 

Fools,

In this post, I will briefly describe one of my favorite current investments, the reasons behind it, and walk you through my investing checklist. I will include a more organized, detailed write-up later, but just wanted to get my thoughts down.

 

The company is Sandstorm Metals and Energy. I first must give credit where it is due. I first read about the company from Ryan O'Connor over at: http://www.aboveaverageodds.com/ Rather than rehash the entire thesis, I will walk you through my checklist and highlight what I find most attractive about the situation.

Company: Sandstorm Metals and Energy (STTYF.PK is the OTC U.S. Version, SND.V is ticker on the TSX)

Current Price:  $0.43

Market Cap: $135 mm 

 1) Have at least a short summary of the thesis on this blog/ in CAPS. This will force me to write my thoughts down, hopefully slow down my process, and also allow me to get alternative views from the Foolish community

Background: 

·         SND is a “base metal and energy streaming company.” It is essentially provides financing to late-stage mining and energy companies in return for a percentage of future production and usually a guaranteed principal repayment within (usually) 5 years

o   I am familiar with this business model because of my ownership in Primero Mining (PPP). Silver Wheaton (SLW) financed part of Primero’s production in exchange for a substantial % of PPP’s silver production at $4/ ounce. This “call option,” which exists for the life of the mine, became extremely valuable to SLW as silver is currently around $35/ounce

o   High debt loads, uncertain development times, and the cyclicality of commodity prices make SND an attractive financing option for companies relative to taking on additional debt and/ or equity dilution

Investment Thesis:

I believe SSTYF is materially undervalued because at the current price, the current market cap is equal to the net cash on the balance sheet + the minimum guaranteed payments owed to the company over the next five years. Therefore, in a worst-case scenario, where all of their investments experience significant delays and/ or commodity prices tumble and their streaming contracts are worthless, you are likely looking at a breakeven investment in nominal terms (although certainly a real loss). This provides significant downside protection to current investors-- while giving them explosive upside potential.

2) Include in that thesis the following: current price, worst-case downside scenario, and price target (ideally a base case and optimistic case). In this way, I will force myself to summarize at what price I like a stock, really like a stock, and think it is a sell.

current price: $0.43, worst-case scenario: $0.43, 2014 conservative price target: $ 1.00

Some of you may immediately be thinking.. worst-case scenario = market price? What are you thinking? Let me explain.

As explained above, there is real downside protection in the form of minimum payments and net cash on BS = current market cap. Given that the minimum payments are backed by the entire asset of the companies they lend to, this is senior-secured (even in bankruptcy they should easily collect the nominal payment back). This makes downside low. 

The upside is obvious here. Just look at Silver Wheaton over the past few years (the CEO of Sandstorm was formerly the CFO of Silver Wheaton). Just look at the potential bottom in natural gas and the type of leverage Sandstorm would have on any type of price recovery. Just look at the CEO's comments, background, and recent open market purchases (good background here: http://www.caseyresearch.com/nexten/nolan-watson).

So how do we obtain a conservative, base-case price target? If you look at their investor presentation, 10X EV/FCF seems like a very conservative estimate given publicly traded comps. 

If we take an end of 2014 price target, then I should add the 2014 cash flow as well, which would be the ~14 mm in 2012 and 2013 (combined) + $25 mm in 2014 + $ 44 mm net cash + $250 mm (10 X EV/FCF * $25 mm) = $333 mm. We then divide by $332.4 mm shares outstanding and get a 2014 equity value of ~$0.68.

*Note, on the shares outstanding, I added the options outstanding for fully diluted, but did not include the substantial warrants because they are significantly below the strike ($.70) with a December expiration. Furthermore, even if they were exercised, the company would have over $108 mm in cash infusion, so this would offset the effect so this is not much of a concern.

That's a pretty attractive IRR for a base case that assumes underlying commodity prices fall more than 20% (see investor presentation.. i.e. their base case for copper is $3.00 versus $3.91 at today's spot).

Now, you obviously get huge upside as well if these commodities increase as the company has tremendous leverage throught their streaming contracts. (You also do much better if the warrants expire worthless.. more on that later).

With those pretty conservative assumptions, to get a nice (although not home-run) return with significant downside protection seems like a strong reward/risk when you consider that you also have huge upside if commodities surge. 

3) The market view, my variant view, and why I think this opportunity exists (why I think I am right)

Market view: At current price, you are paying about book value (value of loans and net cash on BS). This gives zero value to both Nolan Watson's expertise/ management, and I think seriously miscalculates the imbedded optionality of their streaming agreements. These are essentially long-dated, deep in the money call options on various commodities-- but they come with great downside protection.

I think this being valued at book (or at cash + minimum payments.. either way you want to look at it) is flawed. I think this opportunity exists for the following reasons:

 o   Obscure Canadian-based micro-cap

o   Recently spun-off from Sandstorm Gold

o   Trades for less than $1

o   Essentially no operating results/ won’t show up on most screens

As an individual investor, these types of special situations are where I think I can obtain an advantage. 

4) A short summary of the bearish thesis-- this is something I often overlook. It is easy to think about the upside in an investment, but when you slow down and write down a well-reasoned bearish case, it might make you consider some things you may have missed previously.

The bearish thesis would be something like: this company's business model relies on screwing energy companies into bad streaming deals, it only worked for SLW because they bought at exactly the right time, making it more luck and skill. The CEO is overly-promotional, their Royal Coal deal now looks like a bad one, their Donner Metals equity portion is currently at a loss-- this guy might not be as smart as people say. Furthermore, there are a huge number of warrants/options outstanding that will dilute shareholders significantly-- it remains to be seen whether the company will be shareholder friendly.

This is all fine and well-- and we must always respect the bearish thesis, However, I just very much disagree. I do believe Nolan Watson is a smart guy-- and that the success at SLW (to which he contributed) was not just luck, but involves carefully picking deals (he says they pick 1/100 projects to invest in). Furthermore, I think it is an inefficient area of the capital markets characterized by a high degree of company-specific complexity that creates an opportunity for a company like Sandstorm to achieve above traditional bank-lending returns. Furthermore, in terms of the dilution, even my conservative case (which factors in falling commodity prices and the dilution) yields an attractive return. The warrants also expire in December and are exercised at $0.70. This should act as a catalyst. If the stock is above $0.70, I will have an attractive return. If the stock is below, then that huge overhang on the stock is no longer there, and I may actually be better off as a long-term shareholder.

5) Conclusion on buy/sell/ pass

This is exactly the kind of low-risk (although you might not know it without pouring over the financials), high reward, special situation that I love. Strong Buy. 

6)  If buy, sell, or short, what is the proper and prudent allocation? Is it something you want to be aggressive with, or keep as a small % of portfolio. How does it fit into my broader portfolio?

Given the attractive business model, excellent downside protection, impending catalyst (December warrants), and attractive entry point post-spin, I am allocating a large position in my portfolio to this name and look to be a long-term shareholder (perhaps effected by whether the stock gets diluted by warrants or not.. if stock rises above $0.70 before December I may take some off the table and let the rest run).

Best,

Connor Haley 

7 Comments – Post Your Own

#1) On March 05, 2012 at 10:48 AM, Option1307 (29.97) wrote:

Well thought out argument here, nice work!

+1

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#2) On March 05, 2012 at 11:01 AM, XMFConnor (97.85) wrote:

CORRECTION:

in my revision, forgot to update the price target. It should be ~$1.00, not $0.68 given the adjustments.. don't know how that happened 

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#3) On March 05, 2012 at 2:33 PM, Valyooo (99.64) wrote:

Am I going nuts, or is this the same blog you had last week?

Also, why would a company ever use them for financing?  Interest rates are pretty close to all time lows...I can't imagine wanting to give a huge stake + guaranteed money to a company when a lot of companies are borrowing at 4%

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#4) On March 05, 2012 at 2:34 PM, Valyooo (99.64) wrote:

Duh, you gave the disclaimer in the first line about the fact that its the same, my bad

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#5) On March 19, 2012 at 12:36 PM, Option1307 (29.97) wrote:

The more I read about this the more intersted I am, thanks for the great write up and link to the piece by AAOI not sure how I missed that.

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#6) On March 19, 2012 at 1:01 PM, shamapant (80.73) wrote:

So, it's a great idea, I love net-nets. A similar situation I've found would be Aberdeen International(AAB). However, I think you are overlooking some potential downside things(forgive me if i overlooked it in your article or if i'm misinformed, just looking at google finance 'financials'). but 2 main points that I find are common in a lot of net-net situations that I would be worried about.

1. I see that the warrants aren't a big issue, but is just basic dilutive financing an issue?  looks to me like every year or so they have been issuing stock like mad men...they had 6.89M shares outstanding dec. 2010, and now they have 317M shares outstanding....your downside is directly tied to net cash per share so dilution is extremely important to your thesis.

2. based on quick overview, they are cash spenders aren' they? 83M in net cash a year ago, and roughly 43M in net cash now? 

3. google finance is probably misinformed because when I calculate net cash(44/317=.13per share) its a lot lower than market price....seemingly giving you a much bigger downside.

 of course, I haven't done my research, so you could still be totally on to something.

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#7) On June 07, 2012 at 11:26 PM, HGolf92 (94.89) wrote:

^AAB. Dirty.

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