Modern Day Cigar Butts
Ben Graham became the father of value investing by buying bad companies at phenomenal prices. On the heels of the great depression Graham would buy businesses at ridiculously low prices to tangible assets. This is how Buffett started off his investing career as well before transitioning to buying high quality businesses after around 20 years of running Graham-style partnerships.
Buffett has referred to the these types of investments as “cigar-butts”. We occasionally find cigar butts / really cheap stuff. We look at them because they're interesting but we're not willing to compromise entirely on business quality just for a statistically cheap valuation. Though they aren’t what we look for in investments, they’re often fun and and instructive to explore.
Anglo American Coal Mine Spinoff
On Monday Anglo American PLC, a global mining company, spun off Thungela Resources into a new publicly traded entity. Thungela consists of Anglo’s South African coal mining assets. Like many of the world’s large miners, Anglo is under pressure from investors and environmentalists to shed coal assets which are considered the most polluting fuel source. The transaction followed many classic spinoff dynamics. Selling from shareholders who received Thungela shares and didn’t want exposure to the business overwhelmed demand from new investors and pushed the price down. Further exacerbating price declines are the fact that the company’s stock is denominated in the volatile South African rand.
The combination of an ugly industry and shareholders eager to sell regardless of price can create pretty crazy prices occasionally. After a few hours of trading on Monday Thungela’s stock was priced at 1/3rd of the EBITDA it is expected to earn in 2021. That is astonishingly cheap especially considering the company is debt-free and demand for coal is certainly not going away in the next few years. Also, Anglo American pledged to support the company should coal prices fall through 2023, effectively providing a put option for that risk. What’s more, it’s reasonable to conclude that with little investment occurring in new mines the supply of coal may shrink faster than the demand, putting upward pressure on coal prices which favors producers like Thungela. As is often the case, there is more to the story than just forced selling and an unloved industry.
While Thungela has no debt on its books there is considerable uncertainty regarding future environmental obligations. When Thungela shutters a mine they are responsible for clean-up costs and long-term waste water treatment. Thungela has provided estimates of future environmental liabilities but short-seller Boatman Capital contends that the company’s projections are grossly understated. Boatman believes future clean-up liabilities, based on new draft legislation in South Africa, could exceed the equity value of the stock, making the investment a potential zero.
The situation reminds me of Garrett Motion from a few years ago. Garrett, a market leader in turbocharger production, was spun off of Honeywell and saddled with huge asbestos liabilities in an effort to clean Honeywell’s hands. While Garrett is a decent business, the downturn in demand from COVID lockdowns combined with the stifling asbestos payments bankrupted the company and largely wiped out equity holders.
Out of pure curiosity I’ll look at anything that’s trading for 1/3rd of expected earnings, as that’s an exceptionally low bar to clear for equity holders to make money. Valuations like this are usually too good to be true, though not always (Schmitt Industries traded for net cash in March of 2020). Regardless of price, I’m unwilling to wade into a scenario where a) I don’t fully understand the business or important geo-political dynamics and b) I can reasonable imagine a scenario that the investment goes to zero. If a stock checks either or both of those boxes, as is the case with Thungela, I’ll just move on regardless of the upside.
Considering the ridiculously low valuation, likelihood of demand for coal well beyond the next decade, and coal pricing protection from Anglo, it appears the odds are on investor’s side. If I had to bet I’d guess that those willing to take the risk and endure significant volatility and buy Thungela stand to make good money in the stock, but it really isn’t our style. I guess we can leave it to the Reddit forums to take it from here.
The Curious Case Of Air Wisconsin
Air Wisconsin is probably the largest airline you've ever heard of. It's the 12th largest regional airline in the US, carrying 2.5% of all passengers in 2019. They operate under a capacity purchase agreement with United through 2023. Their planes are branded United Express and use United's gates and ticketing. United gets to set their schedules and pays fixed payments for each departure and block hour flown. United also reimburses Air Wisconsin for fuel, insurance, and landing fees. Air Wisconsin merely has to operate the planes. It's kind of like the relationship between a franchisor and a franchisee.
As a result, Air Wisconsin is a more predictable business than United. United has more upside but also more downside. But, Air Wisconsin's business isn't anything to write home about. It's mediocre at best.
What's remarkable is the company's price. At $1.60 per share, the company is worth $115 million on a fully diluted basis. That's only 1.7x 2020's free cash flow and only about 4x my back-of-the-envelope estimate of normalized free cash flow. You usually only see these valuations when a stock is highly levered and teetering on the brink of bankruptcy. But the company has net cash on its balance sheet.
So, what's going on?
Air Wisconsin is a wholly-owned subsidiary of a holding company called Harbor Diversified. Harbor Diversified was a busted pharma company that went dark in 2012. They resumed filing in June 2020 because they breached 300 shareholders.
During the intervening eight years, Amum LLC took control of Harbor Diversified and acquired Air Wisconsin. They aimed to use Harbor Diversified's NOLs to shield Air Wisconsin's profits from taxes.
In 2018 Air Wisconsin signed a capacity purchase agreement with United that runs through 2023. Before 2018, Air Wisconsin had a similar agreement with American Airlines for ten years. United has the option to renew twice for two years each. So, the contract could last until February 2027. These renewals are important because the United contract is 100% of Air Wisconsin's business. If United doesn't renew the contract, it's unclear what Air Wisconsin would or could do.
Air Wisconsin's jets are old and may not be marketable. They own 64 CRJ-200 regional jets that are 18 years old on average. They can probably fly through 2027 if United renews their contract, but they won't last much longer.
Air Wisconsin's free cash flow is huge because they're not spending money to replace the planes. Last year, they charged $27 million for "depreciation, amortization and obsolescence" but only spent $8 million on capital expenditures. Depreciation is an actual expense, and Air Wisconsin can't underspend it forever. Eventually, they'll have to replace their planes, which will cost a lot of money.
To invest, you'd have to believe that United will renew the contract or that another operator will. Then, you'd have to believe that management will do something intelligent with the cash flows.
One sign that United will resign the contract is that Air Wisconsin recruited their CFO from United after they renegotiated last October. Presumably, a United employee wouldn't leave if they knew Air Wisconsin was about to lose 100% of their business.
On the other hand, Delta announced last September that they're phasing out their CRJ fleet. Other airlines could follow. If demand doesn't continue to roar back, it will be a buyers market for planes, and 18-year old CRJ's may not be saleable.
Management is acting like the business will continue to print cash, however. In March, they authorized a $1 million per month repurchase that automatically renews monthly. $1 million per month is an aggressive repurchase. Since Air Wisconsin took money from the government, they can't repurchase shares until September. So, I'm confused why they'd authorize the buyback now. I'm also confused why they're distributing cash when it appears that they'll need to buy new planes in a few years.
The board of directors is stocked with private equity investors who presumably know something I don't. Reading between the lines, it seems that Air Wisconsin doesn't want to be public and doesn't want to file with the SEC. Their disclosures are clear, but only the minimum required by law. I wouldn't be surprised if they go dark or go private again.
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.