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Favorite Special Situation Investment

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February 28, 2012 – Comments (10) | RELATED TICKERS: STTYF.DL , SLW

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, price target: $ 0.68

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. Assuming all of the warrants are exercised, we divide by $487 mm shares outstanding and get a 2014 equity value of ~$0.68.

That's actually 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).

 

10 Comments – Post Your Own

#1) On February 28, 2012 at 7:37 PM, AAOI (99.49) wrote:

Connor,

Thanks for the plug and great write-up. Keep in mind though that those warrants are deep under water with strikes of $0.70. So unless the stock is north of 70 cents by the end of the year, there won't be any dilution. That, and they recieve roughly $115m in cash upon excersice so that needs to be taken account valuation wise as well.

In other words, I think you need to adjust your upside expectations upwards as far as the base case is concerned - and I think you will find that there is indeed "homerun" type upside under a stable commodity price environment.

Best,

Ryan 

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#2) On February 28, 2012 at 8:37 PM, TMFTypeoh (80.59) wrote:

Connor,

 Sounds interesting.  I just breifly read the financials and presentation.   Its going on my watch list.

 

Brian 

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#3) On February 28, 2012 at 10:30 PM, awallejr (79.68) wrote:

I actually bought 4000 shares of this awhile back mainly as a companion purchase to sndxf.  Same business model (which I love), just different sectors.  I am a patient man.

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#4) On February 29, 2012 at 12:49 AM, XMFConnor (97.23) wrote:

Chris,

Thanks for the comments. You are exactly right on the warrants. Adjusting my base case, whether the warrants are exercised or not actually makes little difference once you take into account the cash infusion if they are exercised.

This takes me to a base case of $0.79-$0.84/share in 2014 ($0.79 if warrants are exercised).

Do you know who owns the majority of the warrants? Interested to know who has the greatest motivation to "get the story out" on this stock before December. It looks like either way current shareholders will win.

Best,

Connor 

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#5) On February 29, 2012 at 11:46 AM, Valyooo (99.43) wrote:

I'm sold, I want to buy some now.

Why do these mining companies give up so much to these guys and SLW, rather than using a bank?  This company is kind of like a bank, but takes a lot more out of the company. 

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#6) On February 29, 2012 at 11:55 AM, Valyooo (99.43) wrote:

I have one huge problem with your write up:

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.

I see write ups like this all of the time and they show a clear bias.  There is NO way that two opposite outcomes can be a bullish case.  Either one is good and one is bad, one is bad one is neutral, or one is good one is neutral.  I can't find the current flaw but I notice a lot of people (I have a lot of respect for you so don't take this the wrong way) tend to do this with penny stock energy companies, and silver companies.  I remember reading in a book about silver, that Warren Buffett buying silver was bullish, but that him sellign was also bullish.  Bullish because he saw value when he bought, bullish because he "must have been forced to sell by the government, and his massive selling drove the price down a little bit".  Either something is bullish or its not, you can't flip a coin and win on either side.

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#7) On February 29, 2012 at 12:16 PM, awallejr (79.68) wrote:

Because there is a short term/long term argument.  If you bought the stock now for say .44 and come December those warrants are exercised that means the stock is selling for at least .70.  A heck of a short term profit.  If the stock is selling for less than .70 that means the warrants will expire and less stock dilution, which is good from a long term point of view.

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#8) On February 29, 2012 at 12:44 PM, Valyooo (99.43) wrote:

but if the stock never makes it to .70 that shows a lack of confidence by investors and possibly hard for them to raise money in the future if they have a history of warrants expiring worthless

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#9) On February 29, 2012 at 12:52 PM, XMFConnor (97.23) wrote:

@ Valyooo,

I respectfully disagree. awallejr sums up the point well.

I have a lot of faith in the long-term story here. Just looking at conservative 2014 estimates shows the real long-term potential here.

So as awallejr said, if it makes it to $0.70, we have clearly "won" as that is an excellent short-term profit. If it doesn't, I get to own a larger piece of the "long-term pie" as shareholders like myself will not be diluted.

In terms of a "lack of confidence by investors," that doesn't really concern me. The company does not even need to raise additional capital at this point, so that is not a concern for me. in the LR, I have confidence people will be forced to wake up to the excellent fundamentals of the company and drive the price up to something more realistic to reflect their potential.

Best,

Connor 

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#10) On February 29, 2012 at 3:39 PM, awallejr (79.68) wrote:

but if the stock never makes it to .70 that shows a lack of confidence by investors

Not at all.  The stock could be at .60 by and through December which is still a heck of a return.

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