Oceania Capital Partners

I wrote this post about Oceania Capital Partners (OCP) a few months ago. It was meant to be the first of so called “premium” posts on this site. In other words, I planned to publish it behind a paywall. For a number of reasons I’ve decided not to continue to share my portfolio positions with everyone for free on this site. I’ve had some issues with setting up the system required to introduce premium posts, so there’s been a delay in publishing these posts.

There have been some recent developments at Oceania Capital Partners that have made me decide to still publish the OCP write-up on the public blog. The post does not include the fiscal 2016 results that were released recently, so keep that in mind. Also, OCP’s share price has increased and the discount to NAV has narrowed following these developments.

Oceania Capital Partners (ASX:OCP)

A month or so ago I ran a stock screen for Australia, because I was still finding some other cheap companies there. One of the companies the screener returned was an investment company called Oceania Capital Partners (ASX:OCP). The majority of companies can usually be eliminated from the list of potential investments fairly quickly, but as I learned more about OCP, it became more and more interesting. Eventually I ended up investing in the company.

OCP has a colorful history and the present ownership situation is unusual as well. We’ll first have to dive into the history of OCP a little bit. This backstory is important because it explains how the current ownership of OCP came to be.

History

The company began life in 2004 with its IPO on the Australian Stock Exchange. At that time the company was called Allco Equity Partners (AEP). AEP was a private equity company and also held activist public market investments. AEP was an outgrowth of Allco Finance Group (AFG), a large financial services business. AFG was a large shareholder in AEP and also had an investment management agreement with the company. In 2008, AFG blew up when the sub-prime mortgage crisis broke out and it went into voluntary administration on November 4, 2008. AEP subsequently ended the management agreement with AFG.

Shareholders of AEP were understandably pretty unhappy about the performance of their company. The company held three investments at the time and was trading at a massive 70% discount to NAV. In April 2009 AEP decided to suspend new investment activity and return excess capital to shareholders. Their current investments were to be realized in an orderly fashion. Shareholders were given the right to vote on the future direction of the company in two years time if the discount to NAV remained greater than 15%. The name of the company was changed to Oceania Capital Partners in the second half of 2009.

HCI gets involved

In June and July of 2011 a new major shareholder emerged, HCI Australian Operations. They took a 19.99% position in OCP. This was a few months before shareholders were to vote on the future direction of OCP, because the company was still trading at a greater than 15% discount to NAV at that time.

HCI stands for Hosken Consolidated Investments (JSE:HCI). HCI is a South-African investment holding company with a wide diversity of investments in hotels & gaming, media, oil & gas, bus services and many other sectors. The CEO of the South African company is Johnny Copelyn.

HCI has a market cap of 12.2 billion South African Rand, which is about $1.1 billion Australian dollars. What was this large South African company doing with this tiny investment in a Australian microcap?

In August and November 2011 a proposal was negotiated with HCI and shareholders. Shareholders could either vote for:

a pro rata capital return of $1.45
a capital return of $0.30 and an equal access buy-back of $2.15

The buyback was for a maximum of 72.1% of the outstanding shares. HCI (holding 19.99%) would not participate in the buyback. They also agreed to participate in a rights issue that could follow in the next year, to come up with sufficient funds to do the buyback and continue to be able to operate as an investment company. Investors opted for the second proposal.

This explains broadly how HCI has become the majority shareholder of OCP with 67.7% of the outstanding shares today. It was a smart way for them to get control of an investment vehicle at a discount to NAV that has a lot of tax losses as well. Other shareholders were treated fairly in the process, no one was forced out.

OCP today

HCI has installed two executive directors who are responsible for managing the company and making investments: Michael Jacobson and Brian Scheiner. Jacobson and Scheiner own 2.8% and 2.9% of the outstanding shares respectively. The CFO, Lionel Baldwin, is also appointed by HCI and owns a 0.7% stake.

The management has exited a number of legacy investments and made a few new ones since they became involved.

Today the company holds the following investments:

24.875% of Baycorp: a receivables management company
95% of EON Broadcasting: owner and operator of two commercial radio stations in the Queensland Sunshine coast
97% of Crimsafe: the leading supplier of security doors and window screens in Australia
50% of Cohort: digital lead generation and marketing
Publicly listed securities: $1.7m

As I write this, OCP trades at $1.42 AUD. There are 35.3 million shares outstanding, giving the company a market cap of $51.9 million Australian Dollars. The last reported book value on Sept. 30, 2015 was $84.3 million. OCP is currently trading at a 38.4% discount to the last reported book value.

I’ll discuss the main investments of OCP today:

– Baycorp: 24.875% interest – Receivables management

This is an investment that dates from the time before HCI became involved. Baycorp is a leading receivables management specialist in New Zealand and Australia. This private company is involved with contingency collection services and debt acquisition (Purchase Debt Ledger or PDL).

I’m not a big fan of this sort of business. The results over the years haven been very inconsistent. The competitive nature of the industry and availability of lots of cheap capital makes the PDL business very tough. Like insurance, you can get into big trouble when you’re not selective enough.

OCP owned 52.8% of Baycorp before, but in September 2015 it made a deal with Nasdaq listed Encore Capital Group to sell a part of its stake to Encore for $18.3 million in cash. Encore now has a controlling position in Baycorp.

This is what the company mentioned about its remaining interest in Baycorp:

The price that is payable for the Sale Interest is a cash amount of $33.16 million of which $18.3 million will be payable to OCP. 10% of the total cash proceeds will be paid into escrow to secure any warranty claims that may arise. The escrow amount remaining will be released over 2 years. The imputed equity value of Baycorp for the purposes of the transaction is $66 million (“the Imputed Value”).

There are arrangements for the acquisition of the Remaining Interest by Encore in a period of two to four years from completion. The pricing for such an acquisition would be the result of a market-‐driven process, however in certain circumstances the price would be derived from the Imputed Value.

(Bold text mine)

OCP should have received ~$16.5m as a result of the sale and shareholders might see the remaining stake sold to Encore in the next few years.

Baycorp is the part of OCP that I’m least comfortable with and that I don’t think I can value well enough. I think it is reasonable to just take the valuation at which Baycorp is now carried on OCP’s balance sheet of $34.5 million. The Baycorp stake is held as “Assets held for sale” on the balance sheet. Since almost half of that amount has been received in cash by now, I think this figure should be close enough.

– EON Broadcasting: 95% interest – Two commercial radio stations

EON Broadcasting (EON) is a subsidiary which owns two commercial FM radio stations on the Sunshine Coast – Sea FM 91.9 and 92.7 Mix FM:

Mix FM targets a demographic of 35 plus and plays a mixture of classic and recently released music. Mix FM is number one on the Sunshine Coast for listeners over the age of 35. Sea FM targets an 18-39 demographic and plays predominantly modern and recently released rock music. It commands a cumulative audience of people over the age of 10 greater than any other radio station on the Sunshine Coast.

(Source: OCP Annual Report 2013)

The business was purchased in March 2013 for $17.6 million. As is to be expected, these radio stations have very little tangible assets. No less than $16.4 million of the purchase price were intangible assets: the radio licences that the stations possessed and goodwill.

In fiscal 2014 the radio broadcasting segment reported $7.2 million of revenue and EBIT of $1.9 million. In 2015 revenue was up to $8.9 million and EBIT rose to $2.2 million. EBITDA for 2014 & 2015 was $2.0m and $2.7m respectively. Taking the mid-point of $2.3m, OCP paid 7.7x EBITDA for the broadcasting business. This seems reasonable to me for a business that is relatively stable, has minimal capital requirements and that should generate a nice amount of cash as a result.

The radio industry is not popular with investors and commentators:

You don’t have to look far to find commentators who will tell you that radio is on its last legs. Those commentators do not seem to realise that more people listened to radio in 2014 than in 2013. Radio also continues to hold steady with time spent listening only decreasing minimally year on year – especially compared with other traditional media such as TV and print. There is little doubt that new technologies and ways of listening to music are challenges but the scope is there for adaptation and provided the medium continues to deliver high quality, live and local content to listeners and identifiable results for advertising clients the rumours of death are definitely overstated.

(Source: OCP Annual Report 2015)

OCP might make bolt-on acquisitions in radio:

We have been very open that we would be interested in expanding our investment activity in regional radio but to date we have not identified opportunities that are capable of being closed. We continue to be open to further investment.

– Crimsafe: 97% interest – Security doors and window screens

Crimsafe is the leading stainless steel security screen business in Australia. The business was started 21 years ago and the brand is now represented by a network of 120 licensees across Australia. OCP’s management believes Crimsafe has good growth prospects, especially in the US where they are only doing a limited amount of business currently.

Crimsafe was purchased in March 2015, so we only have limited information to go by. For the six months ended Sept. 30, 2015 Crimsafe showed revenue of $16.1 and profit before interest and tax of $1.5 million. This quote is from the 2015 annual report:

Had the acquisition taken place on 1 April 2014 the operations of Crimsafe would have contributed approximately $37.6 million of revenue and $3.55 million to profit before tax of the Consolidated Entity.

And this is from the press release about the Crimsafe acquisition:

During its financial year ending 30 June 2014 Crimsafe generated unaudited pro-forma revenue of $33.8 million and EBITDA of $4.9 million.

OCP paid $28.8m for their interest, net of cash balances acquired of $2.4m. Of this amount, $11.7m was goodwill and $8.5m was assigned to the brand name. Once again OCP seems to have acquired a capital-light business that should be capable of producing cash. This cash can be used by OCP for other acquisitions.

Once again, I think the price paid looks like a solid deal for OCP at first glance. They paid around 5.9x EBITDA for 2014, but it looks like revenue and profits might be a little lower this year. If they end up with EBIT of $3m for the year ended March 31, 2016 then they will have paid 9.6x EBIT. Perhaps a bit on the high side? But it might well be justified if growth prospects for Crimsafe are as strong as OCP management believes. It is too early to tell at this point.

– Cohort: 50% interest- Digital lead generation and marketing

The 50% stake in Cohort was acquired in October 2014, for $6m. This investment is equity accounted and currently carried on OCP’s balance sheet for $6.5m.

Cohort is described as follows in the 2015 annual report:

Cohort is a new investment for us and we are genuinely excited about the potential growth opportunities for the business. It is truly
a new age digital business and it has shown revenue and profit growth to match. The question is whether that growth was a first blush bloom that will end or whether it will continue from here. Our investment thesis is obviously based on further growth and we are excited by that we are seeing to date. The business has commenced operations in the UK market and if they can be as half as successful there as they have been in Australia to date then that growth will be delivered.

The results for the first seven months were decent:

The equity accounted profit contribution from Cohort for the period of ownership in the year to 31 March 2015 is $0.25 million.

In the latest report for the six month period ended, Sept. 30, 2015, Cohort reported revenue growth of 55% and an equity accounted profit of $0.7m. Cohort paid OCP a dividend of $360k for the period.

Obviously the growth and results for Cohort look great and if it continues, the $6m purchase price for OCP’s 50% stake in the company will look like a bargain. It’s still early days though and I’m a bit skeptical that the business that Cohort is in has any sort of moat. Lead generation and marketing seem more like commodity type offerings to me and I think it is very hard to get ahead of the competition, especially being a small player like Cohort. I hope the business is operating in a sustainable way and is not cutting any corners to get clients good short term results but with possible long term repercussions, like damaging relations with Google. That is something I have seen happen a few times with businesses that operated in this space.

Cohort has made a great start since OCP’s investment though and the investment is relatively modest at $6m. I don’t think there is a reason to haircut the investment at this point.

– Publicly listed securities

OCP owns one publicly listed investment. This is a 5% stake in Atcor Medical Holdings (ASX:ACG). It is a relatively small investment that should currently be worth around $1.7m based on the market price of the stock.

I don’t really understand why OCP is interested in this company. When I briefly looked at a snapshot of the financials I saw a small cap medical device company that is losing money, burning cash and issuing stock to stay alive. I could be missing something obviously. I think Atcor Medical would be impossible to understand for me. I’m very skeptical of this investment. Given the small amount invested by OCP I’m not too concerned about it at this point, but if OCP puts a more significant amount of money into ACG or companies of a similar nature, that would change.

Tax losses?

OCP has $188m of unused tax losses (note 4 of the 2015 annual report). At a tax rate of 30%, the potential benefit is $56.5m.

The same note 4 in the annual report shows a line “Previously unrecognised tax losses now recouped” of $223k for 2015 and $131k for 2014. Does this show that tax losses are now being used? I’m not sure. I don’t understand the subject of tax losses well. I’ve tried to find some information about how these can be used in Australia and how that affects the tax payments from year to year, but I haven’t found much about this.

Tax losses could be another source of value for OCP. It now has two almost wholly owned subsidiaries that are profitable and that should be cash generative as well. If they are able to use those tax losses to decrease their tax payments, more money will be left over to reinvest in other cash flow positive businesses, enabling them to use more tax losses.

Book value and discount

Sept. 30, 2015 book value was $84.3m. After looking at OCP’s individual investments I believe that they are worth at least the amount at which they are carried on the books.

OCP probably does deserve to trade at a discount to book value though. An investor pays for the central costs needed to operate the company. Compensation for the chairman, the two HCI appointed executive directors and the CFO should total around $1.2m going forward. It was higher in prior years, but some changes were made to the board to reduce operating costs.

The company reports “central administration and employee costs” of $2.2m in 2015 and $2.8m in 2014. The 2015 cost are probably a more accurate picture of the costs going forward, due to the reductions in compensation. If we capitalize the $2.2 million at 10% that would give us a liability of $22m. The adjusted book value would become $62.3m and the discount would shrink to 19.6%.

The controlling position of HCI and the extreme illiquidity of the shares might also justify a deeper discount to book value. HCI might decide to take the company private and buy-out minority shareholders at a relatively large discount.

On the other hand, if OCP’s managers are good investors and are able to deliver outperformance then that warrants a narrower discount.

Also, I think that operating costs as a percentage of NAV should go down and become more reasonable over time. OCP has used a lot of cash to buy out shareholders in the 2011 tender offer. This has made the current operating costs relatively high. OCP is still under its first few years under HCI control. The company has made a couple of acquisitions that I think look promising and should produce cash that can then be reinvested. OCP should also have more than $27m in cash right now that could be used in another cash producing investment.

The compensation of the directors should not rise as fast as the asset base. This is also in the interest of HCI itself. The HCI directors have a decent personal stake in the business which should motivate them to increase the value of the company. A quote from the 2015 annual report:

The Company and its majority shareholder are of the view that the Board of an investment company is best comprised of individuals who have adequate experience and who have a financial interest in the success of the Company’s investments.

Much depends on how one views the current OCP management. If you don’t think they are good investors, coupled with the HCI majority ownership and the illiquidity of the stock, OCP might not be cheap enough today. I think you should try to answer the question what sort of discount would make you interested. I think a discount of almost 40% is pretty extreme personally, and something you see more with funds that have a hedge fund type structure and compensation. OCP is different in my view. Of course much of the book value consists of goodwill and intangible assets and many investors will be uncomfortable with that. Personally I think EON and Crimsafe look like good investments and, like I described above, I am comfortable with the valuation of these businesses on the books of OCP. So I’m not discounting the goodwill and intangibles.

HCI’s position as the majority owner

HCI is a long term oriented South African conglomerate. OCP is their Australian vehicle for investing in that part of the world. HCI is in it for the long haul in Australia and seems to have a pretty solid history of compounding book value itself. HCI’s stock price has gone up from 3,750 Rand at the start of 2006 to 11,550 at the start of 2016, a CAGR of 11.9%. This seems like a decent rate, especially considering the fact that HCI’s stock sold off at the end of 2015 and is itself now trading at a discount to book value. HCI itself could be worth a look for investors with access to the South African market. Both the HCI appointed directors at OCP have worked for HCI in South Africa before going to Australia.

Here are a few quotes from Hosken Consolidated Investments’ annual reports since they took control of OCP. This gives us an idea how they view OCP and the role it will play:

HCI annual report 2012:

HCI’s diversification offshore has continued though we believe it is too early to judge progress in these latest developments. We have succeeded in acquiring 67% of a listed vehicle in Australia, Oceania Capital Partners and have a good management team with whom we have a long relationship focused on developing our interests there.

HCI Australian Operations has had a productive first year. Through a series of transactions it has successfully acquired a controlling stake in Oceania Capital Partners Limited (“OCP”), a company listed on the Australian Stock Exchange. It intends to grow OCP and thereby to enhance value for the HCI Group.

HCI annual report 2013:

OCP is a diversified investment vehicle with a broad investment mandate, much like HCI itself. We focus on the Australian and New Zealand regions, although will look at businesses with a broader geographic reach. Our investment philosophy is to invest in good quality businesses which have resilience through different economic circumstances.

The control position of HCI in OCP could be reason for concern. HCI might try to take it private on the cheap or find other ways to disadvantage minority shareholders. A few specific things about HCI make me believe that they will treat minority shareholders fairly.

First, HCI is an investment vehicle itself and controls a number of other publicly traded subsidiaries besides OCP. Bad treatment of minority shareholders could be brought up in future conflicts with shareholders in other companies. It could also make it more difficult to make other deals in the future. HCI has an interest in maintaining a reputation as an honest and trustworthy partner.

Second, a major shareholder of HCI is The South African Clothing and Textile Workers Union and on its homepage HCI describes itself as “a black empowerment investment holding company”. I don’t know how that influences their policies exactly, but this does make me think that a reputation for fair behavior is important to them.

Third, OCP is just a minor component of HCI’s total value. Treating minority shareholders at a small subsidiary like OCP unfairly has probably more downside for them than upside.

Conclusion

After looking at all the components of OCP, I believe the discount of ~38% to the last reported book value for OCP is too large for what the company is today. Since six months have gone by since the last report, the discount should be even a bit larger now. OCP has bought back a few shares in late 2015 and early 2016. That suggests that management also believes the shares are undervalued at this price.

More important, an investor today does not pay anything for the investment performance that OCP’s management might create in the future. While the involvement of HCI in OCP has been relatively short, I believe the way the HCI was able to buy control of OCP on the cheap and the investments the managers have made since then, provide some early indications that these are smart investors that should be able to do well in the future.

OCP could turn into a solid compounder like HCI itself. I don’t think investors are pricing in that possibility at all. OCP was basically reborn when HCI took control and it is still early days.

I am happy to make OCP a small part of my portfolio and I’m not really looking to sell if the discount were to narrow a little either. I think OCP could develop into something bigger and more valuable over the long term and I own it for this reason primarily. Of course my opinion would change if management starts making large questionable investments or if HCI shows signs of abusing the rights of minority shareholders.

Update April 29: Proposed indirect change of control

I’ve worked on this post for a while and sometimes things change when I’ve not published a post yet. This post is an example. I’ve decided not to rewrite the entire post significantly, but to add this update.

On April 28 a proposal was made to OCP shareholders. Under this proposal HCI will cease to be the majority shareholder and its stake will be transferred to John Copelyn’s (HCI’s CEO) family trust. Copelyn will transfer a part of his HCI shareholdings to HCI in return. So these stakes will be exchanged and for HCI it is in effect a stock buyback.

This article also explains the transaction. Non-associated OCP shareholders will get to vote on the acquisition by Copelyn in a meeting, which has not been announced yet.

I have mixed feelings about this proposed transaction. On the one hand I think Mr. Copelyn is pretty smart and this will be a good deal for him, especially if this is a tax free exchange. I think Mr. Copelyn sees significant long-term value in OCP, otherwise he would not try to make this deal. So I think his interest in OCP supports the investment case I have made.

Is this a good deal for minority OCP shareholders though? On that I’m not sure. Part of my reasoning above for HCI not abusing its powers falls away when Mr. Copelyn becomes the majority owner. I would feel less secure as a minority owner when there is a single person in control of OCP and not a publicly traded holding company that receives some benefit from a reputation of treating minority shareholders fairly.

An Independent Experts Report will be commissioned by OCP with respect to this proposed transaction. We’ll see if minority shareholders are offered any assurances for supporting this deal.

Disclosure: long Oceania Capital Partners (ASX:OCP)