ADF Group (DRX)

I have been bottom fishing recently, so the picks are getting a little more speculative, but I think in this one the risks are mostly isolated to the business itself (in this case heavily dependent on the overall economy and interest rates) rather than any financial risk in the company.

ADF Group is involved with mega projects involving steel frames such as office buildings, airports, nuclear power stations, etc... (They are NOT involved with residential housing, which I expect to do poorly for quite some time). Nuclear power stations is of particular note, since they mention they wish to develop this sector given the expected growth potential in the future.

$0.23 per share in cash ($0.44 if you include short term investments), book value of $2.50, debt of $0.28, and total liabilities of $0.60. Current assets exceed current liabilities by 2.5x. Even in the worst case if one of the projects does not go through, and they are forced to sell inventory and assets at fire sale prices, I still estimate the book value to be around $1.00.

There is an implied interest rate on debt of 3.5% (interest expense / total debt), but since they doubled their debt during the period, the interest expense may represent mostly the expense while the loan balance was lower. Still, even at 5%, the interest rate is more than acceptable. This is a barometer of financial health, because it shows us that a bank has done their analysis and considered this company a low enough risk to lend it money at this rate.

Earnings per share we $0.12 (down from $0.22 last year). I don’t see this skyrocketing anytime soon due to the current economic climate. However, as long as they can maintain anything positive, I am happy. The discount on book value is what I am investing for. However, we need earnings in order to gather investor interest. Without it, even though it is undervalued, it will stay undervalued for a long time, and the company would be worth more to me if they liquidated the business than it would if they continued operations.

The company currently has an order backlog of $90M expected to be realized over the next year or two. Current revenues are approx $50M, so in the worst case (2 years), this will be a slight decline to $45M per year.

The company has a policy of not paying dividends and is instead investing excess cash in share buybacks. This is a strategy I used with excellent results in my business class shoe company simulation, so I know very well the positive effects this has on all per share amounts (Even if the company does not increase earnings, they still show an increase in earnings per share on a year to year trend and they are basically buying better financial ratios). They have bought back 1.5M of a planned 2M shares expected to complete the program by the end of April 2011. At these prices, the company buybacks are great value to existing shareholders. Issuing more shares is fine as long as the company receives fair value or more in cash, in the same logic, buying back shares is fine as long as the company pays fair value or less in cash. In this case, they are buying back well below book value, which should be a net gain for existing shareholders since your ownership of the company book value increases by an amount greater than the decrease in book value from the loss of cash.

As far as credit risk, the company is dependent for 90% of its revenues from a single client, but the majority of the clients (including this one) are governments, with very little risk of default or of running out of financing. This does not make this income stream predictable or dependable for the future, but the existing order log should be fairly secure. However, the company noted that the government is much slower to pay because of beauracracy, which would worry me if ADF was in bad financial shape, but it looks strong enough to manage the increased working capital and cash flow requirements without any trouble.

Revenues are in USD and costs are in CAD. This will cause a significant exchange effect, which has been 40% offset by hedging contracts. While hedging can only be done at favourable rates temporarily, and next time it will be more difficult to find a good rate, they should be covered until the end of the existing contracts. Long term debt is mostly based in USD, so this mitigates a lot of exchange risk, since contracts are negotiated years in advance, and being subject to a fixed long term exposure in a currency different than revenues requires short term price adjustments not easily negotiated in advance (especially not in the government bidding process). Also, they are trying to buy materials in USD when possible.

The overall impression I get from this company is that they are very responsible, conservative, and want to focus on their core business rather than add unnecessary financial risks.

One of the biggest current concerns is that they are negotiating contract changes that could have a significant effect on expected revenues. We will need more news to see how this plays out.

SUMMARY: I like it for its balance sheet strength and deep discount against book value, but its future is uncertain. I am buying a small amount and will see where it goes.

Trading: The volume on this stock is currently very low, increasing spreads. Make sure you wait for the spread to close or use limit orders at a point near the bid price, and dont leave an open order for any period of time. Set the limit order just before you plan to trade, and if it is not filled, delete it so that those with level 2 quotes cannot see your interest and act against you (when the volume is this small, even your small order will attract attention). Current price is $1.50, and I expect it could go about as high as book value of $2.50 in the current economic environment and $3.00 or more if the economic environment improves. I don’t believe the price will go below $1.00, since it would be like giving away free money (you could buy the company and liquidate for a profit).

Max,

While this is not related to this particular company you analyzed, It is a question about your math. I've probably asked you this before but I need to know for a FA I am currently trying to work through.

$0.23 per share in cash ($0.44 if you include short term investments), book value of $2.50, debt of $0.28, and total liabilities of $0.60. Current assets exceed current liabilities by 2.5x. Even in the worst case if one of the projects does not go through, and they are forced to sell inventory and assets at fire sale prices, I still estimate the book value to be around $1.00.

Is it correct to assume book value = assets-liability. if so, how did you come up with a book value of $2.50 here?

When starting a FA, if you find the book value to be a negative number, is it safe to say you can stop there because you are just wasting your time on further analysis?


Thanks again for all the help!

Book Value = Assets - Liabilities (the shortcut is to take total equity). Book value per share is book value / # of shares. In this case book value is $88M, and # of shares is roughly 35M. Book value per share = $2.5.

Short answer to your question is Yes, negative book value is definitely a bad sign and I would not bother looking further.

More liabilities than assets means that they have taken the cash from issuing shares and instead of putting it to productive use and earning money for the shareholders (in which case we would have to worry that they are not earning enough money), they have in fact lost the shareholders money. Now I won't say it is impossible to turn this situation around and earn enough profits off the remaining assets to build back up to at least the level of existing liabilities, but it is certainly a dangerous situation to be in and banks can call in their loans and force the company into bankruptcy at that point. If that happens and the liabilities truly exceed assets, the stock is worth $0.

Max wrote:
Short answer to your question is Yes, negative book value is definitely a bad sign and I would not bother looking further..

Except in the case of REITs and some trust funds , where leverage is used to generate income.

That's why book value or NAV is rarely considered when valuing a REIT , usually FFO , or AFFO is considered more realistic.

A REITs liabilities will routinely exceed their assets , but they can still generate income for distributions.

A REIT that is not constantly taking on more debt for aquisitions , is not growing.

OK, interesting. REITs would take shareholder money to purchase one property, then use that property as security to borrow a loan to finance another. I am still having trouble seeing how there would be more liabilities than assets except in falling housing markets. I think it generally holds true that having more liabilities than assets means much more risk, but in the case of REITs, I guess the stable income generation offsets that risk.

Jon, I understand you are a pretty big believer in REITs, could you make a post somewhere explaining how to analyze them, perhaps pick one that you like in particular for analysis. I am not very familiar with the trust structure (basically just taxes all distributions in the hands of the shareholder and does not tax the corporation?), and this structure will soon go away as I understand it, but I would like to understand the effect of the transition on the value of REITs (effectively double taxation in the future.

Sold at $1.66 for 5.75% gain in over approx 2 months. Current price is $1.70.

ADF got a new contract worth $22M (much less when considering the profit margin, but articles are saying it may lead to additional work). Still, it makes them a going concern again, and their stock price has risen to $1.94. I jumped in yesterday at $1.85. Hoping to bail out today at 5% profit or better. Still think there is plenty of room for it to continue to climb. Hope we are finally out of that dry spell for stocks in Feb (accentuated by my massive loss in CCME).