Contributing editor Ryan Irvine joins us this week with a detailed review of some of his previous recommendations. Ryan is the CEO of KeyStone Financial and one of the country’s top experts in small cap stocks. He lives in the Vancouver area. Here is his report.
Ryan Irvine writes:
There has been a lot happening with some of the companies I have previously recommended in the Internet Wealth Builder so this week’s column is devoted to bringing you up to date. Let’s get right to it.
Merus Labs International Inc. (TSX:MSL) (MSLI, Financial)
Originally recommended on March 30/15 (#21513) at C$2.72, US$2.13. Closed Friday at C$3.14, US$2.54.
First off the mark this month I would like to quickly update Merus Labs International, a Canadian-based specialty pharmaceutical stock we just introduced to IWB readers in March of this year. This week the stock closed at C$3.14 for a gain to date of 15% since March.
Background: Merus acquires and licenses pharmaceutical products and then sells them into select international markets. The company co-ordinates these functions from its Toronto headquarters and its operations in Luxembourg. Merus Labs currently has products in the area of urology/women’s health, oncology, anticoagulants, and anti-infective.
Recent developments: In late May, Merus announced that one of its wholly owned subsidiaries had signed a definitive agreement to acquire the rights to manufacture, market, and sell two established specialty pharmaceutical products in certain European and other markets.
The products (Salagen and Estraderm MX) are being divested by Novartis Pharma AG, a leading global pharmaceutical company, for a purchase price of US$29.5 million. Salagen (pilocarpine hydrochloride) is indicated for xerostomia following radiation therapy, in addition to Sjogren’s syndrome. Estraderm MX is a transdermal delivery format of estradiol used for symptomatic treatment of menopause. In 2014, the products had sales of approximately US$10 million in the applicable territories. Merus will fund the acquisition with available cash.
No numbers were provided in reference to the level of EBITDA (cash flow) from the acquired products, but current estimates range between C$5-$6 million on a go-forward basis. As such, it appears the acquisition was made at approximately 6.5-7 times EBITDA. In the current environment, this is a relatively good price. The acquisitions are not company changing, as the Sintrom purchase could be considered, but the new products diversify Merus’ product mix, reducing dependence on key drugs.
This is the first deal for Merus’ new CEO, Barry Fishman. If they are smartly accretive, they will help the street to view Fishman as a solid dealmaker and potentially help re-rate the stock over the next 12-24 months with a higher multiple. At the very least, he has demonstrated that he can execute on an M&A transaction.
We believe that the recent purchases are just the start of a five-year growth plan. In the near term, with over $45 million in cash and further access to capital, Merus has the resources for further growth. Prior to the acquisition of Salagen and Estraderm MX, Merus reported that it had been in active discussions on more than fifteen potential acquisition targets, totaling more than $200 million in EBITDA.
Conclusion: Based on our forecasted EBITDA, Merus trades at EV (enterprise value)/EBITDA ratio of 8.4 versus peers in the range of 12-15 times. The company is finally starting to attract the attention of institutional investors and more Bay Street firms are now initiating coverage. We believe this aids the company in attaining higher multiples over time.
Our fair value estimate on the company remains at $3.75 per share and is based on strong EBITDA growth and the company attaining a more reasonable EV/EBITDA of 11 (still a significant discount to peers). The $3.75 fair value estimate models both a German reimbursement cap scenario (see the original recommendation for more details on that) and the introduction of generics in late 2016. There is upside to this level if a reimbursement cap in Germany for the company’s Enablex (Darifenacin) drug is delayed (or not implemented at all) and/or if Merus can ward off generics until 2019, or the company continues to make accretive acquisitions financed at reasonable prices.
Action now: We maintain our Buy rating on Merus and continue to view the stock as the cheapest specialty pharmaceutical name in the country.
Athabasca Minerals Inc. (TSXV:ABM, Financial)
Originally recommended on Jan. 30/12 (#21204) at $0.485. Closed Friday at $0.62.
Next, we update Athabasca Minerals Inc., which was originally recommended in the IWB in January 2012 at $0.485. With the stock surging to the $2.40 range in the early fall of 2012, driven by two sets of record quarterly earnings, we recommended investors sell half their positions and hold the rest to continue to participate in the solid long-term potential that Athabasca possesses.
Background: Athabasca Minerals is a resource company involved in the management, exploration, and development of aggregate and silica sand projects. These activities include contract work, aggregate pit management, aggregate production and sales from corporate-owned pits, new aggregate development and acquisitions of sand and gravel operations, and development and supply of frac sand for Western Canada.
With the stock moving lower over the past couple months and closing this week at $0.62 we provide an update.
Recent developments: First quarter 2015 sales from corporate-owned aggregate operations were impacted by limited construction activities during the winter months and the spring break up. Coupled with the uncertainty in the region due to the drop in oil prices, oil sands customers cut back and deferred some of the planned projects.
Over its seasonally slow first quarter, Athabasca Minerals incurred a net loss of $1.4 million ($0.042 per share), as compared to a net loss of $1.91 million ($0.063 per share) for the three months ended Feb. 28, 2014.
The company had provided previous guidance that the sales volume from the Susan Lake Gravel Pit would be approximately 6.5 million tonnes in 2015. While lower than at peak periods, this level should still allow reasonable profitability going forward into 2015 if managed effectively. While recognizing that the potential impact of lower oil prices could be significant, management believes that this projected tonnage is still appropriate and conservative.
Sales guidance for 2015 at the corporate-owned pits is 500,000 tonnes. Management continues to strive for production optimization levels and tighter cost controls as it prepares for the heavy demand aggregate season. Strategic inventory was established in 2014 in core areas, which will allow management to quickly react to any sudden demand changes as the economy evolves. Although the demand in the first quarter was lower than expected, management continues to support the sales guidance of 500,000 tonnes.
Athabasca Minerals recently announced that the company’s CEO has departed. Factor in this news with the lower-than-expected first quarter results and lower oil sands related spending projected in the near term and it is not surprising that the stock has come under pressure.
Conclusion: After selling half of our initial positions above the $2 range, we decided to hold the remaining position to participate in the potential of the company’s Firebag Frac Sand Project. The initial numbers for the project appear attractive, but in the current market it may be difficult to raise the estimated initial capital costs of $87.8 million. Management has stated the Firebag Project is on target to be in production by 2016. This appears overly optimistic. There are plenty of hurdles ahead of this date including raising substantial (but not unrealistic) capital if the market settles and we look two to three years out.
Action now: Continue to Hold your remaining position, having already made a significant profit on your original investment by selling half above the $2 range. We are not keen to add to any new positions in the current environment.
Enghouse Systems Limited (TSX:ESL, Financial) (EGHSF, Financial)
Originally recommended on March 7/11 (#21109) at C$9.10. Closed Friday at C$50.60, US$45.
Next we take a look at Enghouse Systems Limited, which was introduced to the IWB in our February 2011 installment when the stock traded at $9.10. We updated the stock in February with its shares trading in the $44 range. Today, we provide another update with the stock closing up smartly to $50.60 in Toronto.
Background: Enghouse is a leading global provider of enterprise software solutions, serving a variety of distinct vertical markets. Its strategy is to build a larger and more diverse software company through strategic acquisitions and profitable growth.
Recent developments: This past week Enghouse reported its second-quarter results. Earnings per share (EPS) were slightly below expectations at $0.28 versus the street projection of $0.30. Revenues were modestly ahead of analysts’ expectations. Organic growth (a figure that is somewhat difficult to break out of the company’s results) turned slightly negative in the quarter (1%-2% estimated). This was attributed to the increased use of subscription pricing and aggressive pricing from software-as-a-service (SaaS) players in the company’s Interactive Management market. Of course, this model can produce less revenue now, but more over time and we expect it to be a beneficial switch long-term.
Conclusion: Enghouse is no longer a secret in Canadian markets. The stock trades at premium valuations as a result of its excellent long-term track record of growth. We believe the company is fairly valued at present, trading at around 18 times adjusted EBITDA, cash out.
The company’s cash is held in Canadian dollars. The drop in the Canadian dollar versus the U.S. dollar has impacted the size of the Enghouse’s war chest as acquisitions are most often completed in U.S. dollars. The decline is offset somewhat by the fact that the company does operate primarily in U.S. currency.
Action now: We reiterate our Hold rating on a valuation basis. We expect Enghouse will continue to outperform the market long term, but the stock is likely fairly valued if one is looking three to six months out.
WiLAN Inc. (TSX:WIN) (WILN, Financial)
Originally recommended on Aug. 30/10 (#20131) at C$5.50, US$5.20. Closed Friday at C$2.93, US$2.39.
Our final update is in reference to WiLAN Inc., which was upgraded to a Buy in November in the $3.80 range.
Background: Founded in 1992, WiLAN is an intellectual property (IP) licensing company that was originally created to develop and commercialize technology that made low-cost, high-speed wireless networking a reality. Today, some of the world’s largest technology companies license patents (more than 4,000 issued or pending) in WiLAN’s portfolio. WiLAN has licensed its intellectual property to over 290 companies worldwide.
Recent developments: WiLAN recently made two significant announcements. First, the company reported that its wholly owned subsidiary, Polaris Innovations Limited, has acquired from Infineon Technologies AG the vast majority of Qimonda AG’s patent portfolio. Second, Polaris announced it had immediately signed a multi-year license agreement related to the Qimonda patent portfolio with Samsung Electronics Co.
Management also made the decision to no longer provide revenue and adjusted earnings guidance on a quarterly basis. WiLAN will continue to provide expense guidance. The company explained that for more than three years it has continuously outperformed its quarterly revenue guidance, often by a large margin. This overperformance is due in part to the fact that WiLAN does not include running royalty payments expected but not yet received in the quarter or amounts from new licenses signed after guidance is given.
WiLAN’s business is evolving, in that increasing portions of revenues are generated by one-time payments in each quarter. The company is also now announcing quarterly results earlier, before many quarterly running royalty reports have been received. These factors increasingly make guidance misleading since, virtually every time, actual quarterly revenues are higher than guidance. We agree that timing of one-time payments can be an issue but many companies deal with this and still provide guidance.
To a degree, the problem in the near term has been one of perception from investors. Many investors count on the “guidance” as goalposts to make their estimates going forward. For a company that has historically provided guidance, the absence of it is a negative, as it appears to indicate a lack of visibility. If the major issue was consistent underestimates from management, then why not increase estimates to make them more in line with what management actually expects, rather than provide nothing at all.
In our mind, what ails WiLAN is not a lack of guidance but inconsistent cash flow growth, despite an increase in the number of announced licensing deals. Couple this some high profile litigation setbacks and management has lost the confidence of the street. The pulling of the guidance was the icing on the cake, sending the shares to their recent lows.
Having said all that, when the news is positive, apparently management still sees fit to issue some guidance. At the bottom of the Samsung announcement, WiLAN revised its second quarter revenue guidance to be “in excess of ” $34 million after previously guiding its revenue to be “at least” $18.3 million. This is a huge step-up in revenues ($15.7 million) and appears to indicate at least a portion of the Samsung deal is one-time in nature. As there are few details on the agreement, investors are left to speculate on the impact going forward.
Conclusion: We see the portfolio patent purchase as a positive as it appears WiLAN may have already recouped in the range of $10 million of its $30 million price tag in one deal. We view the Qimonda AG’s patent portfolio acquisition as a positive and a potentially significantly positive one for investors but management remains in the penalty box until they can deliver what appears to be more consistent quarterly growth.
We expect a very strong second quarter given the Samsung deal and will report further on the company following the announced results. The company’s business environment has also become tougher as WiLAN faces new patent laws and a courtroom environment (particularly in the U.S.) that is (rightly or wrongly) looking somewhat less favourably on the its business model.
Action now: We are downgrading our rating to Hold and do not advise readers to enter new positions at this time.
- end Ryan Irvine
