“Since special situations were in a sense created by myself, they were my life’s work and I knew all about them, I decided to write about them.”

Maurece Schiller, 1959

Dear Friends, Colleagues and Value Investors (and many all three!),

If I’m writing to you with my hand out, it’s for a good reason.

Please consider sharing and supporting @tomjacobsinvest’s and my Kickstarter campaign to right the historical record to give Maurece Schiller, an unknown but enormously influential pioneer of special situations value investing, his due. If you don’t know Maurece Schiller, you’re not alone. In fact, I had a similar reaction when Tom introduced me to his works not long ago.

After all, as a voracious reader, case-study nut, and decade-long addict of all things value investing, I was fairly certain I was aware of every capitalist worth learning about since the Gilded Age – and doubly so with respect to the key figures instrumental to the creation and development of the discipline we practice. (Not to put a too fine of point on it.)

So why, I asked, should I care about an obscure research director from the 1950’s? If he were so important, why don’t I know about him? I mean, there are some areas where it makes sense to be all about confirmation bias.

But then, thanks to Tom, I was introduced to Mr. Schiller’s out-of-print works from the 1950’s and 1960’s. Long before Joel Greenblatt’s seminal work You Can Be a Stock Market Genius, Maurece Schiller literally wrote the book (or, more accurately, wrote the books) on special situations value investing. Indeed, Greenblatt credits Schiller in his famed Columbia Business School class. “It worked then and it works now,” he says to his students, while holding up a worn copy of Schiller’s work.

But because Schiller lacked the connections to start a large investment fund, had an academic bent, eschewed self-promotion, and was committed to reducing individual investors’ risk, he never became more than a blip on the radar beyond a handful of people. We find it a shame that this incredibly innovative thinker and his painstakingly researched works on value investing have been all but ignored by history.

With all of this in mind, my goal in writing you today is a modest one. We have launched a Kickstarter campaign to fund the re-publishing of Maurece Schiller’s five forgotten works on value investing and special situations.

The success of our project depends on you, like-minded people who not only believe in the special situations discipline Schiller helped create, but also the larger mission of value investing writ-large.

Fortunately, in addition to being an unusually wise and wealthy bunch, ours is a tribe that tends to be especially passionate and generous when it comes to all things education-related. Given this reality, our hope is to reach and even surpass our fund-raising goals. This would allow not only print and electronic editions, but also audio. And we’ve put our money where our mouths are, too.

Please join us to support this long-unappreciated inventor of special situations investing, a visionary who deserves his place among the very greatest value investors. The four horsemen – Graham, Buffett, Klarman and Greenblatt – should become five.

Any amount helps. Plus, at certain reward levels, you and your business, blog, group, social media handles and the like will be recognized in one or all of the five re-published works.

Please join us at Kickstarter today!

Update: wonderfully, our initial goal of raising a modest sum ($10,000) to cover the production run of Schillers first five books (read: interior design, cover design, copyediting, printing expenses, and various other ancillary costs associated with bringing these books to print) was surpassed within a few short days. In fact, truth be told, we ended up hitting the mark before we even had a chance to kickstart the first real leg of Tom and my’s coordinated (multi-leg) campaign push. Talk about unexpected.

In any case, to say we’re humbled by the generosity and grateful for the support doesn’t quite express it (language has its limit as they say). As a thank you, we’ll be we awarding all contributors (new and old) with a soon to be announced gift we’ll disclose soon for those willing to help us cross our revised “stretch goal” of $20k. Note this will cover the production of two of the five books in audio format, alongside a few other “accretive” bells and whistles.

And again, all supporters associated with helping us with both the original and “stretch” goals will be able to walk away with a one of a kind, limited edition gift that they’ll love. Trust me on this. Tom and I just spent the last day and a half debating the merits of different gifts and the two finalists we emerged with have us both delighted. Odds are “above average” you will to!

Editors Note: While I initially started cobbling together part 3 a couple of weeks ago prior to the January 6th press release (see the link below), unfortunately the stock proceeded to shoot up ~15% on something like 10x the average daily volume on the news. Yet given an inexplicable 8% selloff a few days after in the face of what I believe to be a legitimate “game changer,” not to mention a major de-risking event, I decided to go ahead and post what remains for those of you who continue to be interested in the longer-term story at Input – with promises of bringing it all together come next week for part 4.

Keep in mind that while normally I’d take the time to update part 3 prior to posting, due to an unusually busy schedule over the next week I simply don’t have the time. In fact, I haven’t edited it much at all at this point and it’s probably twice as long as it would be if I had the time to refine it the way I’d initially intended. Regardless, hopefully members will find it a worthwhile read despite these shortcomings. I think it will be worth the effort – and again, expect a fully up to date part 4 the week after next.     

At any rate, the positive initial reaction was definitely warranted and largely due to Input’s ability to deploy another ~$16.9m into an additional 26 canola streams in the month of December alone, a data point that is particularly notable in a number of key respects. 

For example, the announcement gets the company almost half way to their full year (2015) guidance of $40m, a mere one month into “deployment season”, a period that typically spans from January to May. This was a surprise to say the least given farmers are typically focused on their operations in the October through December period, not to mention the fact that last year the company didn’t deploy any cash until well into January. Point being, the Jan. 6th update may be the most important event in the company’s history, as it highlights the huge demand for Input’s services as well as the long-term viability of its high quality business model. It also hints at what I’ve believed for some time. Namely, that the size of Input’s total addressable market will prove to be much larger than what is currently reflected in the company’s current quote. 

As always time will tell.

Also, if what follows below comes off as disjointed, keep in mind that certain sections of the original piece have been cut given they don’t reflect the latest numbers, in particular the valuation section and a few others that imo were to “early stage” to bother including. Nonetheless, what remains should be plenty sufficient to drive home why I continue to believe the stock is materially mispriced, even if certain parts are somewhat dated.

So with that, enjoy!

January 6th Input Capital Operations Update Press Release

1 Year Later – An Annual Review 

So what’s new?

At a high level, not much. INP remains the world’s first and only agricultural commodity streaming company (no natural comps) focused on providing farmers with upfront cash in lieu of a multi-year, high-return Canola royalty stream. Streams characterized as much by their ability to mitigate risk as by their ability to generate outsized IRR’s. (check out the Q&A at the end of part 2 for some color in terms of the multi layered and essentially government guaranteed downside protection)

Furthermore, armed with what is now a proven model, a hugely lucrative win/win value proposition, roughly $60m in cash to deploy at highly attractive returns, not to mention an almost stupidly large addressable market relative to its current stream count, Input’s potential to sustain a high rate of increasingly profitable growth in both the short and long-run is utterly tremendous. Yet the company remains poorly understood and substantially under-appreciated.

Granted, I suppose this shouldn’t be all that surprising in that Input, like most unique, newly public businesses with no real public or private peers, is naturally a strong mis-pricing candidate. Names like GOOG, MERC, MA and MCO come to mind, all of which looked statistically expensive through the rearview coming out of the gate but turned out to be anything but – indeed, they proved to be tremendous bargains for those willing to look 12 to 24 months out. I think a similar dynamic is playing out here.

In any case, slow canola realization from the 2013 harvest and a variety of other temporary issues – such as an abnormally harsh winter, logistical issues that affected rail availability (congestion resulted in delayed Canola shipments due to a lack of takeaway capacity) and a falling canola price – ultimately drove the stock back below last summer’s $2.30 secondary issuance. The thing is, at~$2.12 per share, I’d argue the present set up offers the single most attractive risk/adjusted reward since the company went public in the middle of 2013.

For starters, Input has started to generate cash as well as proven itself in a variety of key ways over the last year. Whether we’re talking about basic blocking and tackling like arbitraging canola pricing for partners, sourcing capital on increasingly attractive terms, deploying that capital back into new streams at even better terms, etc. it seems pretty clear the business has come along way. Indeed, the only question marks that remain revolve around the absolute size of Input’s addressable market and how quickly the company can scale, two questions I intend to address in detail throughout this update.

Regardless, the business has largely turned the corner and management continues to execute on all fronts. The result is an investment opportunity that has been substantially de-risked, which is why I think it makes a ton of sense to use this latest pullback to either initiate or add to a position. After all, if my appraisal of the situation is even in the ballpark of being correct, time to get in cheap may be running out.

Game Changing Inflection Point

Perhaps the most surprising aspect of the current set up is that “capital deployment season” is right around the corner, and yet the market appears unwilling to assign any credit for the step change in cash flow that should result if management executes according to plan.

Realize that INP will be deploying another $40m + into new streaming contracts at IRR’s of 20%+ over the next few months. Contracts mind you that (at current canola prices) should not only lower INP’s all in costs but come with substantial embedded optionality should pricing ever revert to a level more commensurate with long-term supply demand dynamics. And that’s to say nothing of the fact that the move will effectively double the value its existing streaming portfolio in one fell swoop, further diversifying it’s revenue streams and the geographic diversity of the business.

Point being, I think success on this front should be a “game changer” for INP in the truest sense of the term, effectively demolishing any and all concerns surrounding demand for Input’s services and the scalability of it’s high quality business model.

Which brings me to Input’s present valuation.

Assuming Input successfully invests the $45m in “deployable” cash currently sitting on its balance sheet by the end of the first quarter, the implied pro forma multiple on INP’s normalized or “fully loaded” cash flow would be in the mid to high single digits depending on your view of mid cycle canola prices. A multiple that is far too low in light of the companies management, low risk, high quality operating model as well as the open ended growth runway in front of it, amongst other qualitative factors that have yet to be properly incorporated into Input’s share price.

So riddle me this dear readers. Does it make sense for a competitively entrenched market leader operating in a rapidly growing niche in a growing industry…one capable of sustaining a rapid rate of highly profitable growth driven by accelerating market adoption and funded entirely by internal cash flow for years to come no less…to trade at a mere mid single digit multiple to normalized cash flow?

What about if that same business is run by a proven group of visionary owner operators who not only own ~20% of the company, but possess an objectively superb paper trail vis a vi strategy, operations, and capital allocation?

I think not.

Especially when its highly attractive model has already been recognized by investors as particularly lucrative. After all, all one has to do is look at the valuations of most comparable publicly traded businesses of a similar nature to get an idea of what I’m getting at – as each and every one trades at multiples approximating twice where Input trades today.

Note too that in Inputs case we are talking about a business whose flexible model should be able to compound at 20 to 30% a year simply through organic cash deployment. Of course the actual rate of compounding could prove materially higher depending on future equity raises, but at this point per share value should grow exponentially without raising another dime.

Yet the implied valuation on INP’s “fully loaded” cash flows doesn’t reflect any of this.

At any rate, management continues to deliver on the pioneering strategic plan laid out shortly after the company went public last year. And I’ve never been more confident in their abilities or the long-term prospects of this business. In fact, I’d argue the company’s goal of forging an enduring compounding machine set to absolutely dominate a massive and dramatically underserved segment of the agricultural value chain is all but assured at this point. Especially considering the threat of a successful new entrant is extremely low, at least over the medium-term.

(And besides, given the size of the total addressable market there should be plenty of room for two, or three, or even four players …not saying we’ll see that, just that the “TAM” appears large enough to support more than one player without driving down returns on capital.) 

So for these reasons and more, odds appear rather good that the days of an unsustainably low valuation at Input Capital are numbered. But to understand why that is, let’s turn to how Input got so cheap in the first place.

Why’s it so Cheap?

At the core of the current downdraft, I think a number of factors are at work – all of which are helping to drain investor confidence:

1. Energy & agricultural markets are making people nervous (especially in Canada given relative focus on energy vis a vis the US)
2. Soft canola prices are making people nervous
3. Slow capital deployment is making people nervous
4. A myopic, quarter to quarter view makes people nervous

The thing is, none of these things make me nervous. And for good reason. Heck, investor confidence should be getting better. Much better but it is what it is. In the meantime I’ve simply been adding more.

On the above points…

1. Commodity/energy issues are driving Markets, which is making people nervous

Obviously there isn’t much anyone can do about macro driven market fears, other than to stay focused on the fundamentals (and the “right things” generally), which as far as canola is concerned remain by all accounts quite solid. Of course what happens in the energy markets (barring say a junk bond induced contagion across the capital markets as whole) is irrelevant anyway. And the long running period of tough agricultural prices we’ve seen of late can’t go on forever. If anything, the time to invest is when the short-term challenges are already well known/priced in and hence set to abate sooner rather than later. So periods like today.

That, and it would seem that the long-term viability of Input’s business is no longer in question. If anything, it’s long-term prospects look better than ever. Add in a rock solid balance sheet and an ability to fund growth via internally generated cash flows that makes the health of the capital markets largely irrelevant and I’m at a loss for why long-term shareholders would be nervous. I mean it’s not as if Input needs access to capital at attractive rates to execute its business plan. Indeed, trouble on the capital markets front may actually accelerate progress in that regard.

Then there is the additional comfort that comes from knowing that Input’s financing unlocks real value for farmers on a regular, ongoing basis. A fact that is far more important than say cyclical swings in canola pricing when it comes to to approximating future demand for Input’s services.

For example, one good way to gauge the overall level of demand for Input’s services is to consider just one of the structural drivers briefly touched upon in parts 1 and 2, namely the massive intergenerational transfer of farms set to take place in Canada over the next five years.

With the average age of a Canadian farmer approaching 55 to 60, Canadian farmers as a whole aren’t exactly spring chickens, nor are they likely to get any younger barring the discovery of the fountain of youth. Thus it shouldn’t surprise anyone then that reliable survey’s estimate that a whopping ~75% of these farmers plan to retire at some point over the next 10 years. The thing is, according to those same survey’s, nearly all of them lack a succession plan of any kind.

In light of that, a couple of points should immediately stick out…

For one, we are talking about an absolute fu*k ton of farmers looking to retire and thus, a truly massive market opportunity before Input. Remember that there are over 52k Canadian farmers, so if almost half plan on retiring over the next ten years, then we are looking at a sea of sellers potentially tens of thousands strong. Actually, a tidal wave is probably more accurate given the sea in question amounts to roughly 25k farmers on the high end of the range. Heck, let’s cut that number in half and we’re still looking at a number approximating 13k farmers looking to retire. That’s a lot of farmers no matter how you slice it.

If it’s not exactly clear how INP stands to benefit from the above data point stay with me…it will.

For those of you in this camp, for now I’d think about the market opportunity like this: if recent estimates are credible (and I believe they are), roughly 50% of Canadian land assets worth some $30 billion are set to change hands over the next five years – and that’s just in Saskatchewan alone. Clearly then, we are talking about a truly massive market for any company who can make good money facilitating said transfers.

Second, it doesn’t take a genius to realize these farmers can’t work forever (makes one wonder how many active farmers continue to work past the age of 75…or 70 for that matter). And given that, it seems rather likely that the average farmer will need to find a buyer at some point over the next ten years. After all, farming is by its nature a high impact endeavor that takes a very real physical toll – so this isn’t investing where retirement can be put off indefinitely as long as your mental faculties remain in tact. Far from it.

Third, of those farmers planning to retire, realize that nearly all of them MUST sell. As they’ll need to recoup their capital for retirement…otherwise they’ll have nothing to live on. In other words, over the next decade it seems relatively certain that say 10 to 20k farmers will need to get out of the farming business to fund their retirement, that is unless they plan on working until they literally drop dead.

Hint, this is where it gets interesting…

To make matters worse (or better depending on your perspective), given the relative scarcity of youngish farmers with the necessary financial wherewithal to take these farms of retiree’s hands, it should be clear to even the densest of observers that these older farmers have a significant problem. Especially when you take into account that the average 4k acre small farm in Saskatchewan goes for about $6 million and change these days – and that’s before labor!! Which is a lot of dough for anybody, but especially for cash strapped farmers in their early 30’s and 40’s who simply aren’t old enough to have amassed that kind of wealth.

Keep in mind too that Canadian farms have been appreciating at a tremendous clip for years making an already difficult situation even more difficult. In 2011 for example, land values increased at ~14.3%. In 2012, land values increased ~19.5%. In 2013, land values increased ~22.1%. I could go on but I’m sure you get the point.

As far as rising land values, to be clear, I highlight the trend not because I expect it to continue. If anything, I expect it to reverse and probably sooner than later – as it appears Canadian farm assets are priced far above their productive value and with so many farmers looking to sell, there should be substantial pressure on farm values by definition. But I think it’s important to outline in brief as it provides some much needed color vis a vis the current set up.

Anyhow, safe to say then for young farmers still in the early stages of their career, coming up with a chunk of change of this magnitude is no easy feat. Again, given their relative youth, the odds that they’ll have the cash reserves necessary to finance such a large purchase are low pretty much by definition. And even if they could qualify for a loan of that size ($6m +), there would still be some serious doubts about whether such a loan makes economic or strategic sense in the first place.

For example, even if these hungry, capable young farmers could find an institution to lend to them with little to no money down, at an affordable interest rate…lets say at 5%, with a LTV of 100%…odds are they’d still be in a very difficult position. As they’d still be working capital poor, lacking the additional capital needed to optimize what is now a far larger farming operation. To grossly oversimplify the situation – if the farmer in question’s farm is now roughly twice as large, all things equal he or she would require roughly twice as much capital to optimize their farming ops. Capital they still won’t have despite taking on more debt and having a very real need.

So, you can see why the thought of purchasing an additional farm for those with ambitions to do so might be a nonstarter, or at least an intrinsically high risk endeavor with little margin for error.

Luckily for a) the tidal wave of sellers and b) capable and hungry young farmers looking to expand but short on cash, Inputs here to help on both sides of the transaction (cue Superman theme…kidding).

You see by stepping in with the requisite capital and expertise to help these young farmers not only get bigger but materially more efficient as they grow, Input helps maximize the number of buyers in a position to purchase farm assets while maximizing the profits those farmers will earn along the way.

Or to say it another way, Input is in a position to help these young farmers not only grow their acreage in a prudent and measured way (helping them qualify without say taking on too much debt or overextending themselves in the process), they’re able to help them maximize the overall productivity of that newly acquired acreage in lockstep. In the process, Input should do its part to help alleviate the massive shortage of buyers needed to facilitate a smooth transition vis a vi the intergenerational transfer of farming assets on the come, and in a manner where everyone involved is better off.

But wait, there’s more!

Last but not least, note the the above demographic driven bottleneck will be further intensified by what is perhaps the most important point of all. The fact that Canadian law by and large restricts public corporate ownership of farms, thus the intergenerational transfer that must take place must be facilitated between individuals as opposed to corporations. In other words, unlike in the States, where massive, publicly traded agricultural companies drove the consolidation of US farming assets, the future development of the Canadian agricultural industry will look radically different. This is because “Big Ag” is legally prohibited from even attempting a similar consolidation in Canada.

Of course just because “Big Ag” can’t drive a similar consolidation, that doesn’t mean Input can’t do its part. Granted, Input is publicly traded, but remember it doesn’t take an underlying ownership position in the underlying real estate, nor does it take an actual interest in their partners farming assets per se. No, Input is compensated through a specified number of Canola tonnes set to be delivered over a specified number of years. Which is genius, as not only does this arrangement align incentives in a uniquely powerful way with the farmer, it also happens to provide the company with an end around the existing legal framework that larger ag focused businesses lack.

Take a minute and think about that last point, as it’s the lynchpin that will ensure an enormously powerful tailwind remains at Inputs back for years to come. One that should result in steadily growing demand for Input’s services pretty much irrespective of cyclical swings in the price of canola or the health of the general economic environment.

Before I move on, consider the following charts on Saskatchewan farmland transactions…as they illustrate my last point quite nicely.

So, with the above refresher out of the way, I’m sure we can all agree that any firm with the requisite skill set and financial wherewithal to step in and facilitate these transfers sits in a truly enviable position (read: those with the means and expertise necessary to help alleviate this increasingly large problem). Yet to say INP is extremely well positioned to exploit this trend isn’t quite accurate. Indeed, they are quite literally the only game in town and odds are they will remain so for quite some time.

Remember it took Input’s management nearly 8 years of working side by side with farmers in their prior venture to develop the relationships and expertise necessary to put the puzzle pieces together in the first place. Trust is key and not easily won, and besides, it takes years of building up the requisite domain expertise to be able to look at an individual farm and effectively handicap how the farmer looking to partner can realistically farm both better and smarter. Not to mention all the experience necessary to structure the contracts in a way that properly protects the downside in case things go wrong. After all, not only is every farm different, every farmer is different and hence every farmers needs will be idiosyncratic – thus, the solution to operate their farm in a way that maximizes results and minimizes risk will be different every time. Naturally, underwriting such contracts effectively isn’t a skill set that one acquires quickly or easily. Anyway, I could go on and on but I’ll spare all of you by simply stating that anyone that thinks capital is all one needs to compete in this business is flat out delusional.

On more thing before I wrap it up and move on.

Note that the only other player set up to help ease the burdens of this generational transfer – at least as far as I’m aware – is Farm Credit Canada (FCC). FCC is owned by the federal government and therefore in a great position to help and make some good money along the way. And thank God for that as absent government assistance its hard to imagine how it all would shake out otherwise. Note too that this help is actually beneficial to Input (in a backdoor kind of way) given that when the buyer uses FCC’s low-cost mortgage financing, they will almost always use up all their working capital on the downpayment, which of course leaves a working capital hole in the wake – again, one that Input is ideally suited to help with.

I guess my main point concerning the FCC is that the great thing about family farms is that they need to be recapitalized every generation. And Input is here to help. 

In sum…

This is a BIG market with real barriers to entry and INP is the first and only company with the ability to leverage it for financial gain in a number of hard to replicate ways. And again, none of that is likely to change anytime soon. So getting nervous over weak energy and agricultural markets to the point of getting shook out of your position is crazy as well as embarrassing. Please don’t be “that guy (or gal)”.

It’s also a VERY big deal! For the first time ever, a small company like INP can hold and maintain unique advantages in the most attractive niche in the agricultural value chain – a niche that the company itself created. If INP can capture even a fraction of this market over time, the upside from the current quote stands to be substantial, easily multiples of the current stock price. That much should be obvious.

Which again, is a great reminder why worrying about weak agricultural markets or stock market volatility driven by short-term swings in the price of canola, let alone the price of oil and gas, is honestly flat out nuts. Or at least that’s how I see it.

2. Soft canola prices are making people nervous:

Here we have yet another non-issue for a number of reasons. If anything, the tough period in agricultural commodity prices of late offers savvy investors an opportunity. Granted, I, nor anyone for that matter, has any ability to predict where prices will be six months or even a year from now. Yet even so, that doesn’t prevent me from saying with a relatively high degree of confidence that looking out over the long-term, all signs point to higher prices over time – at least based on the fundamentals and a number of other factors such as the crops structurally attractive supply demand dynamic.

Now if my opinion and quasi forecast bores you, I for one certainly wouldn’t blame you. In fact, perhaps I should just get straight to the point by stating the best cure for low prices is low prices and leave it at that. I honestly think it would be sufficient.

In any case, for those of you who want a bit more than that, realize that the importance of agricultural products like Canola continues to grow globally thanks to a number of secular tailwinds that show no signs of letting up. This makes Canola’s demand profile not only unique but unusually resilient and largely recession resistant relative to most commodities. It also helps explain why demand has grown at well above average rates pretty much non stop year over year, every year, for well over a decade – and why this trend should continue for sometime to come.

So while in many ways your editor is a professional worrier, in this respect I’d counsel you to have no fear. Why? Because despite the recent negative supply/demand imbalance in canola that has undergirded recent price weakness worldwide canola demand remains both strong and growing, primarily thanks to healthy growth across a number of canola’s diversified set of secular demand drivers. Drivers that should easily absorb the recent glut in supply in short order.

That said, for any of you looking for a refresher on the above drivers, note they include Canola’s growing applications in various industrial uses, as well as it’s clear health benefits, and a very real “healthy living” megatrend across the developed west that shows no signs of letting up. That, and in a world that continues to produce more and more middle class people the demand for higher protein diets should increase in tandem. This is because it takes 3x more grain to feed cattle than it does a person, so it’s easy to see how a growing middle class will naturally give way to steadily increasing oilseed (canola) demand for a very long time yet to come.

If anything then, supply will be the issue as Canola consumption is expected to grow ~20% over the next three years based on independent demand drivers that remain in a strong secular uptrend. If you doubt this, note the oilseed complex as a whole has only seen demand contract year over year one time in the last 25 years. Think about it like this: historically speaking, whenever a negative imbalance between supply and consumption materialized, supply led pricing pressure ended up whetting the appetite of end users sufficiently to cause consumption (demand) to rise even faster, eliminating the temporary oversupply pretty quickly. So unless your a malthusian or a card carrying member of the doomsday crowd, why you wouldn’t expect something similar to play out here is beyond me. Indeed, the above dynamic is as old as time and exactly what should happen here. Eventually.

Again, low prices will continue to be the best cure for low prices.

And besides (while we’re at it), why anyone interested in a potential investment in Input, at least those in their right mind, would prefer higher prices given Input is set to deploy potentially ~$90m + over the next few years, is beyond me.  As a soft canola price environment is a wonderful environment in which to sign new streaming deals. Not only does it lock in lower all in cash costs, but it sets up a dynamic that could drive substantial operating leverage over the life of the contract as Canola prices normalize.

I mean how many more silver streams do you think Silver Wheaton would like to have done at $8 silver?

Nuff said.

Now perhaps your concerned that the demand for INP’s streams in a low price environment will meaningfully slacken. Which is another way of saying that you worry that the company won’t be able to put all that capital to work given farmers understandable preference to strike a streaming deal in high price environments (as much as you wish they could). I get it, if only because it’s 100% natural for farmers to prefer to do deals in high canola price environment’s as the all in cost of those deals will be less expensive than when prices are low by definition.

Why is that? Well, when these deals are struck remember that they obligate the farmer to deliver a fixed amount of tonnage every year over the life of the contract, so any deal struck when prices are low automatically becomes more expensive if prices rise/normalize after the fact. In other words, the ideal time to do a deal from the farmers point of view is at a cyclical top, not a cyclical bottom like we have today.

Even so, I think this worry is a complete non issue as there are offsetting factors that are beyond the scope of this discussion, as well as a number of great reasons for farmers to do streaming deals completely outside of cyclical price considerations (usually these deals will be more related to accomplishing strategic goals such as purchasing a neighbors farm). Of course with deployment season right around the corner, we will know soon enough if recent lows in canola end up restricting INP’s ability to put money to work.

Another reason to look at cyclical swings in pricing as a relative non factor worth worrying about when estimating Input’s intrinsic business value has to do with the way these deals are set up. Specifically as it relates to the length of each contract. For example, because Input’s contracts are only 6 years in length (compared to the life of the mine with metal streamers), the company’s portfolio is akin to a cycle neutral bond ladder that responds to the price cycle. And because food is always consumed instead of stacked up like gold or silver, there’s always a fresh new market to supply every year.

Moving on, let’s address the topic that is probably on everyone’s minds by now – what is a proper “mid-cycle” or “normalized” canola price? Or said a bit differently, has your previous estimate from part 1 & 2 changed at all? And if so, why?

The answer to the latter question is no. As far as the former, it appears most industry observers believe that an appropriate mid cycle canola price estimate approximates $500/t, or a level exactly in line with my own, which remains the same as it was late last year.

Also, management estimated as much in a recent call of mine – noting that they see prices fluctuating between $400 and $600 over time, with the understanding that the higher or lower the price, the less time it will stay there.  Interestingly, they expressed they’d be willing to bet that the spot will fluctuate between $450 and $550 about 80% of the time over the life-cycle of a contract.

Q: While a $500 mid cycle price is great and all, but what happens if prices stay depressed or go lower from here for a long time before returning to $500 or above (as you estimate)? Could Input start burning significant amounts of cash for a sustained period of time? How much flexibility does the business have if your completely wrong about the direction of canola pricing in the medium and long-term?

Well, for one, that would be fantastic for all the reasons already discussed above. So let’s hope they do. The more money INP can invest while prices stay low the better if my estimate is correct. As far as the question on burning cash, my answer is that there is basically zero chance of this happening…at least for any significant period of time. In fact, as you’ll see below, odds are extremely high that this is a business that should generate excess cash at every point in the cycle.

As far as the last question, I’ll defer to others on that answer but it’s a great one, as it gives us a great opportunity to discuss/highlight some important insights about the substantial advantages that come from operating such a high quality model (not to mention the enormous downside protection it provides).

So, to illustrate the above advantages, let’s turn to the following analysis from Canadian investment bank M Partners whose report from September lays it out nicely…

“Despite being unfounded, we believe recent weakness in the canola price could hurt INP’s share price, driven by the classic Keynesian beauty contest, “…we devote our intelligences to anticipating what average opinion expects the average opinion to be.”

There are four reasons why we believe short-term canola price weakness 
should not result in INP share price weakness: 

1. INP locks in its basis level shortly after harvest and signed delivery contracts at prices that the company considers attractive based on its view of the then upcoming harvest. Input’s quarterly average realized price per MT has been consistently higher than the average cash price each quarter by an average of 11.2% per quarter. At 11.2% above the current Nov14 ICE exchange spot price of $393.60/MT, you arrive at $437.68/MT, well above the average all-in cost/MT of $300.
2. Given significant cash on the balance sheet of ~$60M, the company has the ability to shift the sale of canola in and out of quarters in order to best time seasonal market prices. The current canola price weakness is reflective of seasonal weakness as the November contract represents the ‘harvest price.’ Farmers mostly sell into this contract in order to have sufficient working capital for the following year resulting in seasonally low prices (excess supply). INP has the ability to defer sale into the future when prices normalize resulting in its above average selling prices. 

3. Although INP has the flexibility to shift sales of canola in and out of quarters, as discussed above, most farmers do not. As canola prices weaken and farmers become concerned that the price might dip below the price required to comfortably finance the following years harvest, it provides a great marketing opportunity for INP. The company has already noted that it is capitalizing on weak canola prices to market their model, similar to rail delays causing the inability to sell canola last year. INP’s model de-risks canola price movements as it impacts a farmers working capital.
4. Short-term canola price weakness has limited impact on the sum of the parts for INP as the company’s targeted IRR of ~20% is achieved with a 6yr average selling price of $410/MT. In Figure 1 we exhibit a 6yr average canola selling price sensitivity to the company’s IRRs, assuming an average all in cost of $300/MT, the average of its existing contracts. In Figure 2 we exhibit the rolling November contract price going back to 1982. Although the dynamics of the canola market have changed over time, it does exhibit that prices do move cyclically and are generally on an uptrend. Investors must therefore look beyond month-month canola price movement and put it in the context of INP’s 6yr canola contract. In a weaker canola price environment management has noted they can lock in slightly lower all in costs/MT in order to temper some risk of short-term canola price weakness.

For these reasons we believe it prudent that investors utilize a NAV calculation concurrently with P/Adj. CFPS. We use a NAV at a 20% discount rate on INP’s Adj. CF as it encapsulates the life of the existing contracts and a terminal value assuming a conservative 2% growth rate and 10% discount rate. When utilizing a NAV, single or multi-quarter shifts in canola prices downward have a very modest impact unlike a one-year forward CFPS which consensus utilizes to value INP. Within this context we believe any share price weakness reflective of short-term canola price movements should be capitalized on by investors cognizant of the insignificance short-term price weakness has on INP’s 6yr contract IRRs.

Input continues to execute; deploying capital into new contracts, diversifying geographically, and selling canola at an average 11.2% premium to spot, reflecting the strength of the company’s marketing program. We continue to rate INP a BUY, with a $5.00 target, based on 12.5x our F2016E adj. CFPS, supported by 1.0x NAV of $6.10. INP is currently trading at 5.8x F2016E adj. CFPS and 0.4x NAV, this compares to peers at 17.0x 2015E CFPS (SSL at 11.7x) and 1.4x NAV”

All great points for sure!

Lowest Cost Wins…

As readers of this blog know well, wether we are talking about canola or any commodity for that matter, when your operating in a commodity industry whoever has the lowest cost of production wins. Always. After all, things can always get worse before they get better and stay that way for longer than you’d rationally expect. Given that, the odds of staying alive for any commodity driven business are naturally much higher the lower down the cost curve a business finds itself. Thus, if you own a commodity driven business, the lower your cost the better your business and the less you have to fear from temporary price locations in the commodity that supports it.

That in mind, let’s walk through some examples that highlight the fundamental quality and overall flexibility of Input’s business model as it relates to falling prices. After all, at the very least they will help illustrate why INP should generate positive cash flow under pretty much any reasonable future scenario I can imagine.  It also offers some very powerful additional data points that should make anyone considering a position stop and think about the many layers of downside protection supporting the present valuation – first liens and government guarantees aside.

For example, assuming my estimate of INP’s average all in COGS of ~$288/t is correct, a number that’s inclusive of both cash costs and the MCapex associated with its upfront payment, note its still well below the absolute lows in Canola ($353/t) in the midst of the financial crisis. In other words, even if we assume a further collapse in pricing along the lines of what happened in the worst recession since the great depression, INP will continue to generate cash.

Let’s get a little more extreme though and use the average price of Canola over the last 30 years (which is really downright silly given how much things have changed over this period but let’s run with it…). Yet even here, it’s still higher than Input’s run rate all in costs, costs mind you that will go much lower as INP pours money into new streams at much lower Canola prices.

Then there’s the global canola consumption/production ratio, a commonly used metric to determine price direction and how it’s supportive of current prices but by now I’m pretty sure everyone gets the point so let’s leave it at that.

Of course we could discuss how the rolling five year average Canola price is ~$535/t, a level that’s substantially above the present spot as well as my normalized estimate used in my valuation estimates, or other reasonable future scenarios and the implications that flow from them but I’ll leave others to explore upside scenarios on their own time.

3. Slow capital deployment is making people nervous: Input Capital’s “deployment season” is highly seasonal

Of all these reasons to get spooked in this stock, perhaps this is the absolute dumbest of them all and the best illustration of how even a full year in to its new life as a public company Input Capital remains poorly understood.

For example:

• The company announced only $201K in deployment last quarter, but that is a quarter in which they never expected to deploy capital in the first place.  This is because farmers are busy farming.

• In fact, they’ve never deployed a single dollar in the October thru December quarter, yet many analysts still expect them to do so.

To use a farming analogy, the lead up to Christmas is Input’s season to plant a lot of seeds in the minds of farmers and lay the groundwork then harvest that activity in the form of streaming deals in the January through May period, period otherwise known as “deployment season”

Misunderstandings aside, a legitimate concern vis a vis capital deployment – one that I’ve been monitoring carefully since my original investment, is how exactly management has been going about building the backbone of a platform capable of sourcing a geometric increase in deal volumes without sacrificing an inch in terms of underwriting quality or depersonalizing the personal and “hands on” nature of these partnerships. In fact, it’s a critical concern, so naturally I’ve spent quite a bit of time pressing management on the scalability issue. In particular, the specifics of how they’ve been going about creating a premier platform, one capable of rapid scalability and the potential to leverage for years to come.

That said, the good news is that after pressing management for some time now my worries have largely abated. Time will tell as far as exactly how successful they’ll be in this regard, but at the very least the “grand master plan” makes a ton of sense to me and I’m highly confident they’ll get it right. And besides, to date they’ve delivered exactly as they said they would.

For any of you skeptics out there, I encourage you to reach out to management on the topic as I’m sure you’ll get exactly the type of candid, thoughtful answers that is the hallmark of my interactions with these guys. Indeed, I’ve found them to be rather exceptional across the board. Of course I could always be a bit delusional too!

Towards that end then, I’ve copied “an exec that shall not be named” response below from some of my pestering a few months back.

“We are prone to try to under promise and over deliver. I have tried to avoid specific guidance, preferring to let analysts draw their own conclusions.  But I will usually tell them where I think they are out to lunch, or where they get materially off course from my own internal figures.  The closest we come to guidance is with the future tonnage volumes we publish on page 21 of the corporate presentation, but I really see that as disclosure – that’s actual contracted tonnes, with an allowance for how those tonnes might shift around from year to year.

From the outside, it is easy to assume that $40m a year in deployment should be a slam dunk, and it may well be.  But we just don’t know yet.  That’s the big remaining question – in fact I think there are two that are related to each other:  (1) what is the scalability potential of the business?  (2) how fast can we get there

On (1) – there are 52,000 canola farmers, and we currently have 21 of them as customers.  We believe large numbers of them can benefit from what we have to offer.  But is this a 30,000 potential client business or a 300 potential client business in reality?  We don’t know yet.  Either way, we can build a solid thriving business.

On (2) – time to get there is a combination of education-driven market-adoption, and our own bandwidth.
During our first deployment season, we did $20 million with one guy (Gord), no back office, and some legacy clients from our pilot testing stage.

During our second deployment season, we did $23 million of deployment with one guy (Gord) + some extra part-time hands whose networks we tapped into, and one guy in the back office (Matt). Those year 2 clients were new to us, so more education was required, and Gord was also handling our grain marketing program for all of the first year crop.

We’re headed into our third deployment season, which started Oct 1.  

For bandwidth, we’ve done some additional things as well:

1. Gord has a full-time dedicated team now, and you’ll see these guys on the website.  Kim, Dennis Joerg, and Warren give us boots on the ground in each province, and they bring their own backgrounds and networks and experience to the table.  Their presence massively reduces turn-around time on new contacts because they already live closer (our Northern Alberta contract is an 8 hour drive from the Edmonton airport, each way, after flying there from Regina, via Calgary).  Their networks bring new names to the table.  And their own credibility means those are warm contacts.

2. The sales process is supported by a substantial marketing program of farm trade shows (we’ve only ever done one in the past, but are booked for 12 in the next 9 months), print advertising in local weekly newspapers, radio advertising on farmer targeted radio, print brochures (for the first time), and various other outreach methods.  This is all run by Kendra, who used to run the marketing and sales management efforts for her family’s farm equipment manufacturing company.

3. Grain marketing is off Gord’s desk and on Brennan Craig’s.  He’s our new full-time grain marketing guy, and brings 18 years of canola industry experience to the table with large international grain companies including Seaboard, Viterra, and as a floor trader at the Winnipeg Commodity Exchange with RBC Dominion Securities.

He knows everybody in the industry, and his entire focus is on moving our canola from the farm to the elevator or crusher in a smooth fashion, while garnering the best possible price.

4. On the back office side, we’ve streamlined and standardized more process, and we hired our outside legal counsel’s paralegal to come in-house and manage all our documentation.  Faster turn-around, and dedicated in-house experience, plus more cost-effective.

So our sales bandwidth has better than quadrupled, and they are well-supported with an education campaign that we believe will yield results.  We’re experimenting with a lot of new channels to see what gets traction. Whatever does will get lots of emphasis.

Nothing you’ve said is crazy, but we’re a new company with a new idea that is different than what most farmers have ever seen. Just like any technology adoption curve, we haven’t yet reached the inflection point where ag streaming goes mainstream, but we will reach that point somewhere along the way. (Just like cell phones and the fax machine. (Who bought the first fax machine, anyway?)

This week, we had a conversation with a current shareholder who used to own a John Deere equipment dealership.  He understands what we are doing.  He told a prosperous farmer friend about what we do and asked if he would ever do a streaming deal – the answer was “that’s only for guys who don’t have any money”.  The reaction of the former equipment dealer was that this reminds him of farm equipment leasing 15-20 years ago.  The book on equipment leasing back then was that leasing was “only for guys who don’t have any money” but that now 90%+ of all equipment is leased.  The paradigm and strategy had to shift, and it started slowly and then more quickly became a normal part of farm finance.

He thinks we’ll go through that same thing at Input. It starts slowly and builds, and then there’s some kind of catalyst that shifts market acceptance into high gear.  We think we’re getting closer to that – we’re starting to get some testimonials which any farmer should find compelling, and the word will start to spread. Soft canola prices right now also help – farmers can’t afford to be too complacent or rest on the laurels of the past few years.

So that’s a long answer to your question.  It’s premature on my end to say whether $40 million in deployment this season is conservative or aggressive.  The funds might fly out the door by Christmas, leaving us to source more capital before January.  Or not.  We just don’t know yet, and we’re not about pumping up expectations beyond what we believe to be conservatively realistic.  But as you can see from above, we’re putting the machinery in place to ramp things up.”

So, as the above exchange makes clear, management is in the process of laying a thoughtful foundation for the future as far as their ability to effectively deploy a large and increasing amount of capital for years to come. And again, I think they’ll succeed and any concerns surrounding the scalability of the business will ultimately prove unfounded. If I’m right about that, odds seem good the stock will react in a big way – better yet, shareholders should make an enormous amount of money over the next five to ten years, which is infinitely more important than near-term price swings. Here’s to that!

4. A myopic, quarter to quarter view makes people nervous:

Surprise surprise but Input, or any business for that matter, should be analyzed on an annual basis…not that this is a crowd that needs to be reminded of such things, it’s just that the extent of investor myopia never ceases to amaze me. That’s certainly the case here.

Then again, it’s this type of perverse market psychology of quarter-to-quarter results that cues up mispriced assets on the regular so its hard to complain. As without it, the opportunity for investors willing to go against the herd would cease to exist but I digress.

Point being, the fact that management has to consistently remind investors that any quarterly results should not be compared against the previous quarter, but against the same period last year, is frankly baffling.  And Input doesn’t have much history to compare against yet.

As, the CFO put it:

“I think those willing to invest before there is a five year history will be the “early bird that gets the worm”.

I couldn’t agree more.

Stay tuned for part 4 soon…

The Q&A has been organized by subject, with the question and subsequent responses each noted. The content has been lightly edited for grammar and the questioners handles have been removed for privacy’s sake. Otherwise, questions that could have been grouped together under a same subject have been kept with their original titles.

*** 

Hi AAOI – two quick questions. If I did the math right, it’s trading for roughly 2x book value right now? Also, the crop protection is only on volumes right, not if canola prices fall? Thanks!

If you’re using invested capital as a proxy for book value, yeah, a little less than 2x I think. That said I believe the optimal way to value a business like this is on its cash flows, not asset value. 10 to 15x seems more than fair.

On price vs. volumes, yes. Crop insurance is based off of a 10 year weighted average on volume (with recent years given more weighting than the older years). The price is set once per year on or around December 15th based on forward market conditions and the crop environment. December is chosen based on normalization of price versus yearly volume both in Canada and US.

In terms of getting comfortable with canola price dynamics, the average cost of production is hard to measure because it’s always yield dependent. You can spend $300/ac and get 30 bu/ac or 60 bu/ac, depending on weather. In one case, your cost is $10/bu and in the other $5/bu. In retrospect, I probably should have added some analysis here.

That in mind, with the price of other agricultural commodities where they are, you would expect farmers in aggregate to reduce the number of canola acres grown if the price fell below $400/tonne (so that’s your downside price support). Earlier this year, canola was over $600 per tonne. Ultimately, the price will rise and fall with the vegetable oils complex, which is driven by soybean and palm oil supply/demand/prices, but that range ($400 to $600) is a decent working range in the current post-trade war (ended in 2006) environment.

Hope that helps!

AAOI

Thanks AAOI. The only thing I’m not clear about is you said price was set Dec 15th. Is that for the crop insurance, so that you are protected if prices fall below that Dec 15th price; or does crop insurance have nothing to do with price levels, but is just volume insurance?

Ah yes, my bad. The answer is that crop insurance is volume insurance, but the price is known.  There are several options to insure the price part – this is very well outlined in this document: http://www.saskcropinsurance.com/cropinsurance/publications/guide01_e.pdf.  See pages 10, 11, 14-17.

This year, the base price for canola coverage is $545 per tonne (against a Nov 2013 futures price just above $480 per tonne – this is because prices were high when the price was set).

So a farmer with a crop insurance claim this year will get paid a higher than market price on lost yield (except for the fact that the crop was so good this year, there is likely no one with a claim).

If prices are low at the time the price is set, a farmer can opt for the variable price option, which allows him to pay a higher premium to capture some upside price movement, if it happens.

Make sense?

AAOI

Yes, got it, thanks for the explanation.

If many of Input’s farmers bump production per acre by close to 100% as you suggest and assuming others are able to do this as well to remain competitive over the medium/long term, won’t this cause canola pricing to collapse; and if that does happen, won’t that significantly impair Input’s business model?

Or, should this not be a concern because it is too far down the road; and/or Input’s farmers and others who copycat Input will make up too small a percentage of the overall market to make a difference?

You nailed it with the latter part of the question. Remember demand is growing at a solid clip too on a secular basis, usually a few percent faster than overall supply. That said, during the few periods where a negative supply imbalance has persisted for any material amount of time, lower prices tend to reignite demand at a faster rate than supply, which typically works through such short lived imbalances rather quickly.

At any rate, perhaps I’ll start worrying about INP’s effect on canola prices when Input’s 20x its size.

As you point out, what makes this so interesting is that the company is making the pie bigger . . . much bigger.

I talked with the one farmer I know well — a Nebraskan corn farmer — and asked him about the idea of such large increases in crop yields based on the factors you raised.

First, he does not know the specifics of rapeseed. And he acknowledged that crop yields could quickly double (for example, in some parts of Africa) where better/more seed, use of fertilizer, rotation of crops, irrigation, etc. could easily more than double yield in one season. Obviously, the exponential growth of crop yields is what is responsible for capitalism and Malthus being wrong (thus far).

However, he also found it difficult to believe that there were large numbers of farmers in the U.S. or Canada that would be that inefficient before the arrival of Input. “Farmers that are that stupid are not in business for long.”

My comments are obviously anecdotal and from a corn farmer in Nebraska so we should all take with a grain of salt, but two questions:

• Is there something unique about rapeseed farming (e.g., its novelty, industry structure, regulation, etc.) such that there are still such large pockets of inefficiency? Is it all a lack of capital or just ignorance?

• Have you verified independently with rapeseed farmers that there is such inefficiency? One thing my friend noted was that you cannot simply look at crop yields versus the average as land and irrigation quality play a huge role and make some land much more yielding than other land.

Thanks

xxxxxxxx,

Great questions, I had a corn farmer in Iowa react similarly. The more I dug the more I learned it was about much more than the insular nature of Saskatchewan farmers.

But to your points:

1. It is generally not ignorance, although there are pockets of ignorance. It’s the capital intensiveness of it, coupled with a demographic-driven turnover and an industry consolidation all at the same time. Add to that new farming practices and seed varieties which blow old practices out of the water, but which are more capital and input intensive, and practically every small farmer in Canada has a real challenge to keep all the balls in the air. For what its worth, I just saw a trailer for an upcoming movie about farmers – you get a feel for that a bit in the trailer – http://www.farmlandfilm.com/

1. It is not an instant, straight-line correlation between automatic higher yields through optimal working capital and agronomics. But it definitely works over time – the compound growth effect of doing the right things all the time improves a farmer’s productivity and profitability. But remember that with an inherent cost of capital as high as the farmer has today using existing tools, it is worth the farmer doing the deal with Input anyway. All that yield upside is gravy – for the farmer and for Input. As far as independent verification, one of my partners has been to a few of these farms and discussed the issues with them but these are just two out of tens of thousands of farmers, so not the most reliable of sample sets (obviously). Then again, I can say that every piece of anecdotal evidence I’ve come across points towards a massive inefficiency that is very real.

Hope that helps.

AAOI

Interesting write-up. The enormous operating leverage can’t be overemphasized particularly if they can write deals for more than 6 years.

What are the capital requirements for fertilizer storage? If fertilizer arbitrage is the real business why does INP need to make a 6 year outlay and absorb all of the associated key man risk of a farm?

The gov’t guarantee reminds me of an Allied Cap SBA loan. What is the gov’t view of these transactions? I don’t believe the intent of their put option is to make a potentially usurious investor whole?

What are the mechanics of auditing the streams and physical product w/ small private farmers? The fraud risk for models like SLW and FNV would appear lower given the counterparty.

One thing to keep in mind when thinking about the size of targetable addressable market (“TAM”) here is that Input doesn’t rely on most of the farmers being ignorant (they aren’t) or undercapitalized (they can be) in the first place. This is critical. Input only needs a select few which would benefit from their working capital assistance. For example, this winter that number is 4%.  Or said another way, Input only needs 1 farmer in 25 to need assistance with working capital for some reason or another (acts of nature, growth, family reason, etc.) for there to be ample demand for their streams.

Here is some simple math that highlights the point: Input is looking to deploy tens of millions in cash this winter and is getting in front of the top 1,500 canola farmers to do so. Per Inputs CFO, out of that 1,500 subset, only about 20% of those farmers are so well capitalized they are out of INP’s total addressable market altogether. So that leaves 1,200 eligible farmers for Input to sit down with in the coming months in hopes of striking 20 to 30 valid streams – which again, amounts to less than 4% of the 1,200 top farmers with a self identified need for working capital assistance on one level or another.  When you start to think about it like this you get an idea of how truly spectacular the value creation runway in front of the company is but I don’t want to get off point.

AAOI

xxxxxx,

Just saw this, will circle back later tonight when I have more time to get to the rest. In the meantime, let me try and answer why we aren’t worried about Input’s relations with the Canadian government/farm Bureau.

First there is the fact that doing these deals is a great deal for all involved. So it’s a symbiotic, not adversarial relationship between Input and the small farmer, and everyone knows this. In other words, what Input does is an unambiguously good thing. They just so happen to make a lot of money doing it. There are worse things, no?

With regard to farm insurance, Input does not directly receive the crop insurance in a downside case – the farmer does.  Yet there are two ways Input implicitly accesses this protection: 1) fixed bu/ac and previously mandated prices which (when multiplication is involved) specify minimum dollars to Input instead of who knows what in a variable scenario; and 2) Input takes 2^nd lien on the farm. Go ahead and blow the proceeds – Input will just take your farm…

Lastly, a key team member, Gord Nystuen, was the Chairman of the Skw Crop Insurance Corporation. http://www.inputcapital.com/About-Us/gord-nystuen.html. One cannot emphasize his position enough when discussing farm regulation and crop insurance at Input. If the former chairman is involved, we’re pretty sure the government is not going to be an issue going forward. If anything, we think the government will help spread the word.

AAOI

As you point out, what makes this so interesting is that the company is making the pie bigger . . . much bigger.

I talked with the one farmer I know well — a Nebraskan corn farmer — and asked him about the idea of such large increases in crop yields based on the factors you raised.

First, he does not know the specifics of rapeseed. And he acknowledged that crop yields could quickly double (for example, in some parts of Africa) where better/more seed, use of fertilizer, rotation of crops, irrigation, etc. could easily more than double yield in one season. Obviously, the exponential growth of crop yields is what is responsible for capitalism and Malthus being wrong (thus far).

However, he also found it difficult to believe that there were large numbers of farmers in the U.S. or Canada that would be that inefficient before the arrival of Input. “Farmers that are that stupid are not in business for long.”

My comments are obviously anecdotal, and from a corn farmer in Nebraska, so we should all take with a grain of salt, but two questions:

1. Is there something unique about rapeseed farming (e.g., its novelty, industry structure, regulation, etc.) such that there are still such large pockets of inefficiency? Is it all a lack of capital or just ignorance?
2. Have you verified independently with rapeseed farmers that there is such inefficiency? One thing my friend noted was that you cannot simply look at crop yields versus the average as land and irrigation quality play a huge role and make some land much more yielding than other land.

Thanks

xxxxxxx,

Great questions, I had a corn farmer in Iowa react similarly. The more I dug, the more I learned it was about much more than the insular nature of Saskatchewan farmers.

1. It is generally not ignorance, although there are pockets of ignorance. It’s the capital intensiveness of it, coupled with a demographic-driven turnover and an industry consolidation all at the same time.  Add to that new farming practices and seed varieties which blow old practices out of the water, but which are more capital and input intensive, and every farmer has a challenge to keep all the balls in the air.

I just saw a trailer for an upcoming movie about farmers – you get a feel for what I’m getting at in the trailer – http://www.farmlandfilm.com/

2. It is not an instant, straight-line correlation between automatic higher yields through optimal working capital and agronomics.  But it definitely works over time – the compound growth effect of doing the right things all the time improves a farmer’s productivity and profitability.  But remember that with an inherent cost of capital as high as the farmer has today using existing tools, it is worth the farmer doing the deal with Input anyway. All that yield upside is gravy – for the farmer and for Input. As far as independent verification, one of my partners has been to a few of these farms and discussed the issues with them but these are just two out of tens of thousands of farmers, so not the most reliable of sample sets (obviously). Then again, I can say that every piece of anecdotal evidence I’ve come across points towards a massive inefficiency that is very, very real.

Hope that helps.

AAOI

xxxxxx,

Ok, just getting back in the saddle. The rest of my answer is below…

On fertilizer, this is not a fertilizer arbitrage business. Sometimes, the explanation of the value Input brings to the relationship/farmer can make it sound like there’s an arbitrage. But if there was, the fertilizer companies would be doing it. The problem for the fertilizer companies is that they produce a product all year round that is used in a 60 day window each year. In order to turn their inventory and their cash flow, they need to keep it moving. So the benefit of this can accrue to a farmer with the right storage who has the cash. That’s not the business the fertilizer dealers are in – which is all about turning their inventory as often as possible.

On auditing, there are lots of tools for auditing a farmer, including the crop insurance audit system, financial and accounting audits, pre-harvest yield inspections, and R&D check-off systems. Ultimately, a farmer has to deliver their production somewhere official (it’s not like there is a back alley market for semi-truck loads of canola), and every one of those deliveries is recorded and hence can be audited. Plus, when Input has a farmland-backed mortgage security position on a farm, it tends to discourage bad behavior as you might expect.

Last but not least, personally I think there is greater risk that an ounce of gold goes missing than 2.6 tonnes of canola (1 oz of gold = 2.6 tonnes of canola at market prices, roughly). It’s hard to stick 2.6 tonnes of canola in ones shoe and walk out :).

AAOI

As I look at the unit economics, I am having trouble figuring out how this is a good deal from the farmer’s perspective; and ultimately from the company’s.

From the write up for the avg farmer:

• Yield: 25-30 bu/acre
• Rev: $150-250/acre

The high end of the range implies an average price $370/ton, and the low end $265 ($265/ton x 25bu / 44.1 bu/ton = $150)

Per the write-up, in exchange for $300/acre the company receives 0.26tons/yr (770tons/year from a typical 3000acre farm in one example and 888tons/year for a $1m investment in another).

Assuming $370 (the high-end of the pricing range) a farmer whose yield stays a 30bu/acre is much worse off:

No deal with the Company:

• Working Capital: $200/acre
• Revenue: $250/acre
• Profit: $50/acre/yr

Deal with the Company:

1^st year:

• Yield: 0.68tons/acre
• Company’s take: 0.26
• Residual to Farmer: 0.42 tons
• Revenue to Farmer: $182/acre (0.42tons*$370+0.26*$100)
• Net Profit to Farmer: ($68)/acre

This is less than the minimum necessary for the following year’s working capital.

Thus, the farmer has to deplete his $200 by $18 to meet the following year’s working capital needs and $50 for his living expenses (assuming that was the use of his profit when no deal with the company).  After 3 years he’s lost his $200/acre and does not have enough for the fourth year’s working capital.

Obviously, should a bad year require a claim on his crop insurance, he is much worse off:

No Deal with the Company:

• Revenue: $175/acre, based off of 70%x$250=$175
• And he has to raise $25 to generate $50 profits the following year and the year after that…

Deal with the Company:

• Revenue: $105/acre, based off $175/acre -(0.26tons x($370-$100))=$105
• And he has to deplete his $200 by at least $95 to go back to the scenario above “Deal with the Company”

I might be missing something.  Could you please share your math per acre?

Thank you.

xxxxxx,

Couple points of clarification:

1. Recall the farmer is receiving up to $300 per acre for his entire farm while he will typically have one third in canola, with the other two thirds being rotated crops such as wheat or peas. As such the farmer is receiving the ~20%+ crop yield improvements on the other 2/3rd of his farm and keeps 100% of that. Input is focused on the Canola (highest yield disparity), yet the farmer views the stream holistically with respect to his entire farm.
2. Depending on the increased canola yield, the farmer could actually be flat to modestly negative with respect to canola, yet profit greatly from his other crops’ extra yield. In other words, the fact that the farmer breaks even in terms of canola doesn’t really mean anything. Indeed, it is the rest of the profit from the productivity improvements in the other 2/3rd’s of his acreage that really matters to the farmer’s bottom line.
3. Input really wants to maximize their canola take, yet needs the farmer to act rationally and his own best interest with respect to the canola crop. As such, Input tries to leave the farmer 40% to 50% of his pre-Input crop when they strike a stream. Leave the farmer any less and he won’t care about the crop; leave the farmer more and Input leaves economics on the table.
4. The value accreted to both Input and the farmer is dependent on yield improvement. From our understanding, the farmers that are doing streaming with input are vastly under-producing versus their land potential.
5. From our conversations with management, the $150 revenue per acre pre-Input may be low. We kept the number in there to match company documents. The real output is probably $200 to $250 per acre, which implies a lower yield than 25 bu/ac at today’s prices.

Hopefully that helps! Some clarification as it relates to your comments specifically is coming up.

AAOI

I’ll come up with a better walkthrough when I have time, but here are a couple more thoughts on your specific example below… [Quotes in italics. Responses in bold]

***

“As I look at the unit economics, I am having trouble figuring out how this is a good deal from the farmer’s perspective; and ultimately from the company’s.

From the write up for the avg farmer:

• Yield: 25-30 bu/acre
• Revenue: $150-250/acre

The high end of the range implies an avg price $370/ton, and the low end $265 ($265/ton x 25bu / 44.1 bu/ton = $150)”

These figures are not just for canola, but figure in a variety of other crops – this is only meant to give an example of grain & oilseed economics on a non-crop specific basis.  Canola tends to be the money maker, so these numbers are lower than canola numbers.

“Per the write up, in exchange for $300/acre the company receives 0.26tons/yr (770tons/year from a typical 3000acre farm in one example and 888tons/year for a $1m investment in another)

Assuming $370 (the high-end of the pricing range) a farmer whose yield stays a 30bu/acre is much worse off:

No deal with the Company:

• Working Capital: $200/acre
• Revenue: $250/acre
• Profit: $50/acre/yr”

The $370 is not the right number here.  Current market price is around $500/tonne [in November 2013].

“Deal with the Company:

1^st year

• Yield: 0.68tons/acre
• Company’s Take: 0.26/acre
• Residual to Farmer: 0.42 tons
• Revenue to farmer: $182/acre (0.42tons*$370+0.26*$100)

This is less than the minimum necessary for the following year’s working capital.

Thus, the farmer has to deplete his $200 by $18 to meet the following year’s working capital needs and $50 for his living expenses (assuming that was the use of his profit when no deal with the company).  After 3 years he’s lost his $200 and does not have enough for the 4^th year’s working capital.”

Substitute $500 for the $370 – note that this yield is still barely just average.  Using the right agronomics, this yield would be considered a major disappointment.

“Obviously, should a bad year require a claim on his crop insurance, he is much worse off:

No Deal with the Company:

• Revenue: $175/acre, based off of 70%x$250=$175
• And he has to raise $25 to generate $50 profits the following year and the year after that…

Deal with the Company:

• Revenue: $105/acre, based off $175/acre -(0.26tons x($370-$100))=$105
• And he has to deplete his $200 by at least $95 to go back to the scenario above “Deal with the Company” 

Crop insurance isn’t meant to be a money maker.  It is meant to keep a farmer in the game. That’s it.  

(Clearly farmers feel like there is a clear and demonstrable benefit in working with Input, or they wouldn’t be signing up.)

Hopefully this is a helpful walk though on the unit economics from the farmers perspective…

Think of the farmer’s income statement on a per acre basis. Based on a 40 bu/ac yield and a $12.50/bu price for canola:

• Revenue: 40 x $12.50 = $500
• Costs: $300
• Profit: $200

Cash Flow Statement:

• Cash at Start of Year: $0

• Cash from INP: $300
• Revenue: $500
• Total Cash In: $800

• Cash out to INP: ~$90
• Expenses: $300 (including his own labour)
• Total Expenses: $390

• Cash at End of Year: $410

Repeat for 5 more years, but roll the year end balance forward to start the next year.

Here is the P&L and Cash Flow Statement without Input: 30 bu/ac yield (lower) @ $12.50/bu (same price):

• Revenue: 30 x $12.50 = $375
• Costs: $250
• Profit: $125/acre

Cash Flow Statement:

• Cash at Start of Year: $0

• Cash from INP: $0
• Revenue: $375
• Total Cash In: $375/acre 

• Cash out to INP: $0
• Expenses: $250 (including his own labor)
• Total Expenses: $250/acre

• Cash at End of Year: $125/acre

Repeat for 5 more years, but roll the year-end balance forward to start the next year. On the face of it, with Input, the farmer has $285/acre more. However, this is before accounting for working capital needs for the following year. And this is where it becomes even more apparent how Input helps the farmer.

The farmer without Input does not have the necessary working capital in the subsequent year to finance his inputs (pun intended), so he has to borrow the $250. Assume he borrows at 10% and that adds $25 per acre to his costs. Then he buys his fertilizer only when the credit is available, so he pays more for it. Let’s say that costs him another $30 per acre. And when he gets to harvest, he is forced by the terms of his borrowing agreement to sell early and that this costs him 5% on the revenue line ($18.75/ac).

So in reality, the situation looks like this for the 30 bu/ac yield @ $12.50/bu scenario when not partnering with Input:

• Revenue: 30 x $12.50 x 95% = $356.25
• Costs: $250 + $25 + $30 = $305
• Profit: $51.25/acre

Cash Flow Statement:

• Cash at Start of Year: $0

• Cash from INP: $0
• Revenue: $356.25
• Total Cash In: $356.25/acre

• Cash out to INP: $0
• Expenses: $305 (including his own labor)
• Total Expenses: $305/acre

• Cash at End of Year: $51.25/acre

Repeat for 5 more years, but roll the year-end balance forward to start the next year.

The logic of a deal with Input becomes pretty obvious, unless the farmer wins the lottery or inherits something from a rich uncle.

Make sense?

Thank you for your detailed response.  I don’t want to seem unappreciative of the time and effort you put into addressing my questions.  However, I think there are a number of inconsistencies.  Let me just mention two:

1. The write-up mentions $150-250/acre of revenue for a yield of 25-30bu.  Now you say $200-250/acre.

Fine, let’s use that range.  The implied price is $353/ton or $8/bu for the low end and $367/ton or $8.3/bu:

• $200/25bu=$8/bu  ($353/ton)
• $250/30bu=$8.3/bu  ($367/ton)

In the response to my question you are using $12.5/bu or $551/ton (despite mentioning $500 as the current trading price).

Naturally, a much higher price than the typical range makes the royalty stream look great…

1. The write-up states that a farmer must invest $200 to achieve the revenue and yields above (i.e. $150-250/acre and 25-30bu).

In your response you use $250.

In my opinion, an investor would be well-served to evaluate the royalty stream under typical conditions, which the write-up (and I guess the company’s documents) depict as $150-250/acre and 25-30bu.

I guess I am interested in one thing at this time: is the $150-250/acre and 25-30bu wrong?  If so, which is the correct range for the typical farmer?

Thank you.

Realize that each number will be different on a farm by farm basis, and both the company and the write-up use numbers that are meant to be indicative of the true economics at work. Your pointing to “inconsistencies” without a difference for a reason I can only presume is that you think I’m playing around with the numbers to justify the unit economics. I mean no disrespect here but please, you’ve got to be kidding.

Without understanding the basic premise that the stream makes each party better off (or they wouldn’t sign the deal), using microeconomics on a handful of farms without material, non public data is useless. Personally I don’t want to walk down that rabbit hole but I will answer your one question as best I can.

Furthmore, the write-up figures you are referencing of $150-250/ac of revenue are all commodities, including canola (the highest value) and other crops in the rotation like wheat and peas.  Those are whole-farm numbers.

Current average canola yield is 30-32 bu/ac at $485/MT ($11.00/bu) = $330 – $352/ac gross revenue per CANOLA acre

So is the $150-250/acre and 25-30bu wrong? 

Hell yes! That is if you think your average farm in Canada only grows canola.  The thing is, there is no such thing as a “canola-only” farm the way there are say “corn-only” farms in the US. Nevertheless, try to understand tht those figures are an accurate reflection of the archetypical farm that is undercapitalized and not using optimal farming practices.

So clearly you are very numbers-oriented, but I really think you are trying to extrapolate oranges from apples, and apples from bananas.  There are many, many moving parts on a farm and in the economics of a farm.  What we’ve tried to do here is create illustrative examples at a very high, but simplified level, because most people don’t want to/can’t drink from a firehose of numbers over the course of a write-up. That, and we wouldn’t want Input sharing details at that level of granularity anyway for competitive reasons. Or said another way, the “differences” you are pointing to are in actual reality just us coming at it for you from different ways – all in a manner meant to be reflective of the same underlying Truths.

Make sense?

In any case,  it’s not necessarily what numbers your looking at that matters here, it’s what those numbers actually mean. For example, what’s important is that farmers are signing up for Input’s program and relatively seamlessly at that – and again, these farmers aren’t desperate.  They could have gone on the way they were, without Input’s capital, gradually pulling themselves up by their own bootstraps.  But again, if they have a need, when presented with this opportunity, it makes total sense to them and Input’s success rate signing up farmers with a self-identified need for working capital is extremely high. So that’s the proof in the pudding that it makes sense. Real farmers in real life are signing up to do deals with Input at a very high rate.

Of course you can play with your micro model all day that says these deals are bad deals based on wrong inputs and a very narrow understanding of how these streams work as well as the myriad of nuances related to farm economics, etc etc – but who wants to do that?

And besides, I would think that you of all people, would understand how dumb it is for a newly public market leader like INP to spoon feed potential investors to the type of degree you suggest. Which again is sheer crazy-ness given the size of the value creation runway still in front of the business, not to mention the extremely large amount of money this high quality economic model should spit out along the way.

For example, come the end of next year INP should be able to deploy say $30m + in cash every year thereafter and at some truly spectacular rates. Better yet, odds seem unusually good INP could grow the $30m dollar amount it could put to work at still wonderful terms by a factor of 20 to 40 fold and yet it would still be a tiny fraction of what the business could ultimately grow to assuming the fullness of time.

Anyhow, the bottom line is that I took this tact because…

a)     most people don’t want that many numbers anyway (that’s just the way it is); and

b)     Input doesn’t want to overeducate potential competition.

It’s that simple.

Regardless, in the meantime I’d encourage you to get to know them yourself and walk through the economics with both management and a farmer or two (if you can manage it).  And I appreciate the pushback and realize you appreciate my earlier responses (rest assured I’m thankful for all the work you did here as well), it’s just that I’m not going to discuss it ad infinitum or run through hoops trying to explain the concept any further from this point on out. After all, why spend a bunch of time walking through the math and various nuances re these deals if all that is likely to come of it is a prolonged session of spoon feeding potential competitors. Definitely not my style these days.

Thanks

AAOI

Thanks for a very extensive writeup.

One question – you use pre-tax numbers.  What kind of tax rate should one assume for this entity?  I’m not familiar with the streaming business.  Is there some special tax status or is this just taxed like a normal corporate entity?

27% if memory serves. Normally streamers do have substantial tax advantages but that is not the case here.

For those who are interested, Input just announced some interesting new hires as far as building out this years deal pipeline. Doubt multiple “farmers of the year” would join an organization that did not indeed add tremendous value to the small farmer.

http://finance.yahoo.com/news/input-capital-corp-expands-business-220000701.html

***

REGINA, Nov. 6, 2013 /CNW/ – Input Capital Corp. (“Input“) (TSX Venture Exchange: INP) announced today the addition of three well-known and top quality farmers to its Business Development team.

Kelvin Meadows ( Moose Jaw, Sask ), Warren Kaeding ( Churchbridge, Sask ) and John Cote ( Saskatoon, Sask ) are all previous winners of the Saskatchewan Young Farmer of the Year award, and join Gord Nystuen, Vice-President of Market Development, to greatly enhance Input’s deal generation and processing capacity.

“We are excited to have Kelvin, Warren and John join our team,” said President and CEO Doug Emsley . “They are all well-known, successful and highly respected farmers on the Saskatchewan and Canadian agriculture scene. Their work with Input Capital will enhance our geographic footprint in multiple areas of the province simultaneously, allowing us to rapidly grow our deal pipeline.”

That in mind, naturally certain aspects covered in parts 1 and 2 such as the stated stock price, f/d share count, implied valuation, cash on the balance sheet, and so on are all somewhat dated, and thus will need to be reworked for anyone that’s new to the story here. At least for those of you who’d rather not wait until next week. Even so, one thing remains the same – Input remains a grossly mis-priced and under appreciated high quality business on the cusp of a multi year period of sustained super compounding. So while the stock has run up quite a bit since I took a position, the reality is that Input offers a far better risk/reward today than at perhaps any other point within its relatively short life as a publicly traded company. 

In fact, earlier this month the company announced a number of details that taken together, have not only brightened Input’s longer-term prospects but materially de-risked the business in the process. And yet the market barely noticed, sending the stock up some 15% on roughly 10x normal volume – only to give back about half of those gains since. At any rate, while I’ll dive into these latest developments in detail in a bit, for now let’s keep “first things first” and start at the very beginning to get a better feel for the business and it’s ultimate potential.

So, readers meet Input Capital. Input Capital, meet readers. My hunch is some of you will become fast friends – not to mention make an enormous amount of money together over the next 2-3 years and even then, that’s just the beginning. Indeed, this owner operated snowball is just getting started.

You can mark my words on that!

Enjoy!

Ryan

****Part 1 – A Field of Streams

If you build it, they will come . . .

In the constant hunt to bring you recommendations worthy of your hard-earned investment dollars, your editors couldn’t be more pleased to bring you this month’s recommendation: Input Capital Corporation (INP.V, INPCF).

Input Capital is the world’s first agricultural commodity streaming company. Think of it as the Silver Wheaton (SLW) of farming. If you’ve never heard of it, don’t worry. Input’s initial public offering was only two months ago. Most investors don’t even know it exists.

What does Input do, exactly?

Simple: It offers money to farmers to help them finance their farms and become more productive, and in return, Input gets a “stream” on these farmers’ future crop production. Input buys the canola after the harvest at a predetermined and heavily discounted price.  Input’s profit is the difference between the price it pays the farmer and the price canola trades at in the market.

This is a great deal for farmers, as it not only provides them with some much needed flexibility and upfront cash, but productivity-improving expertise critical to optimizing the profitability of their farms. The end result is a much more productive farmer. Which is just a fancy way of saying a farmer with a lot more money than he or she would have had absent partnering with Input. Of course, Input makes out like a bandit too. After all, its average return on invested capital for these “streams” should clock in at ~30% + over a full cycle, but let’s not get ahead of ourselves here. Better to start with a high level walk on the mechanics of these deals for illustrative purposes and we can go from there.

That in mind, let’s start with the following example, we’ll call it exhibit A. In this case, Input will provide a farmer with an upfront $1 million payment.  Input will then receive a “stream” of 770 tons of canola at a fixed price of $100 per ton annually for 6 years. But what’s that worth you ask? Well, if assume a reasonable mid cycle canola price of about $500 per ton (note canola was trading north of $600 earlier this year), quite a bit actually, as Input would stand to generate annual cash flows of ~$308,000 a year, which of course equates to a yield of about a 30% on invested capital every year over the life of the six year contract. Of course the fact that the unit economics of a streamer are as good as they are is certainly no surprise to this crowd but then again, it wouldn’t be right if we didn’t lay out a simple walk like this to hammer home the point.

But it gets better! First you need to keep in mind that these steaming contracts entitle Input to receive additional “bonus” tons that offer extra upside if productivity is particularly good in any given year (typically this amounts to 15% of the crop yield over 30 bushels/acre). Yet these bonus tons are more of a side show in my mind given what really starts to make the numbers get crazy is when you start to factor in Input’s ability to reinvest each year’s cash flows into even more high-yield streams!

As an aside, if you don’t know by now, Above Average Odd’s has a special place in its heart for exponential compounding machines and Input may be one of the best natural compounders we’ve ever seen. Of course time will tell but assuming the model works as well as it has to date and management can execute on a level commensurate with their capabilities, we don’t think it’s a stretch to say we may be on the ground floor of what we think will be a truly magnificent five year period of exponential growth in per share.

Think that’s hyperbole? Take a look at what the company’s done in the last year. With 10 streams in place and a balance sheet that will fund an additional 20-30 streams this year, the snowball has already started rolling. And this is the type of snowball that the bigger it gets, the faster it should grow (here’s to hitting escape velocity sooner than later!).

You see Input’s “breakthrough” value proposition is very much at the heart of why we are so excited about this undiscovered franchise’s future. For the farmer, gaining access to critical working capital is just the beginning.  Input also provides access to bargaining power with grain handlers and input providers like fertilizer. For example having the cash to buy fertilizer during the fall off-season saves the farmer as much as 20-40%.  Having the cash to pay also means the farmer gets a 3% discount and doesn’t have to carry interest costs, which frees up more cash. And of course, the more excess cash a farmer has at his disposal the more they’ll be able to invest in profit maximizing inputs that should enable their farm to become more materially more productive than it would have been possible otherwise.

Think about it like this: instead of traditionally spending $200 per acre to generate crop revenue of $150-250 per acre, the farmer can now invest $300 on inputs which should allow him to generate ~$300-450 per acre. And that’s to say nothing of all the ancillary benefits that come from Input providing these farmers with a consulting agrologist to help him or her maximize productivity in other ways. You see by implementing best practices such as: soil testing, seed treatments, precision seeding, weed control, timing and application of operations, and crop residue management, the efficiency gains start to pile up fast.

Or consider for a moment that the average canola crop yield in Canada is about 25 to 30 bushels per acre.  Yet the true potential of this farmland when combined with best practices and proper investment in farming inputs could produce as much 60 to 70 bushels per acre. Now I don’t know about you but that’s a stunning delta, one I didn’t expect to find and my US farming contacts told me shouldn’t exist. But then I verified it for myself and studied it to the point where it actually started to make 100% sense – that is given how radically fragmented the CA market is relative to say the US.

Anyhow, in light of the above reality, clearly the difference in overall productivity between the least productive farmers and those who have the financial and intellectual capital to implement best practices in Canada is tremendous. Better yet, it’s the win/win exploitation of this massive gap for the benefit of poorest and least productive that is at the heart of how Input adds value. And trust us, given our analysis of the plight of your average Canadian small farmer and structural factors ongoing in the industry it’s hard to imagine any shortage of willing takers for the services INP’s offerings, at least at any point over the next decade, but who knows.

Another key point to think about here is the clever way these deals were struck in terms of incentive alignment. For example, the structure of the streaming contract guarantees Input Capital with receive a fixed number of tonnes, which by definition allows for substantial upside to the company’s partners if they can make their farm maximally productive across the other 2/3rd’s their crops, not just canola. Simultaneously, this also incentivizes Input to help make the farmer as successful as possible given the company is entitled to a piece of the upside as well, which again, is typically 15% of the crop yield over a 30 bushel per acre hurdle rate.

One Streamer to Rule Them All

Let’s take a moment to savor how beautiful of a business this is. After all, Input retains basically all of the great qualitative attributes that I love about the stream finance business model and practically none of the negatives. Indeed, as a guy that’s deeply familiar with both, I’d be lying if I said I didn’t wholeheartedly believe that Input possessed far and away the best iteration of an already superior business.

Bold words, but before you rush to judgment, consider a few distinguishing characteristics that are singularly unique in the stream finance world.

1. No production delays.

With Input, there is no extended period of time waiting for a mine to be developed.  Crops are planted year after year generating production immediately.  For example, every single one of Input Capital’s existing streams will generate high margin revenue and cash flows by the end of the year.

2. No exposure to capex overruns or to the fragility of the capital markets.

As I witnessed with Sandstorm Metals, hard rock streaming companies will always be indirectly exposed to the mining sector’s ongoing immolation of capital. But this will not happen on farms – i.e. there will not be any crop input overruns (pun intended).

Additionally, with Input one doesn’t need to worry about external factors such as the health of the general economy/capital markets or the negative reflexivity that turmoil there can wreak on metal streaming company’s future prospects. So unlike with precious and base metal streamers, Input isn’t dependent on mines getting up and running on time and on budget, the capital markets playing ball or any of the other issues that can kickstart a dreaded “death spiral” or other issues that can end the life of your average mining company in six seconds flat.

3. Fortress-Like Downside Protection.

Another critical difference separating Input’s model is the presence of Canadian government backed crop insurance. This is absolutely critical to understand because it makes the odds of a bad crop bankrupting Input’s streaming partner(s) essentially nil, as this insurance covers ~70% of the farmers historical total crop production, which we should note is substantially in excess of the tonnage owed to Input.

In other words, every stream Input purchases they receive not only comes with an asymmetric call option on canola pricing along with a hedge fund like performance fee, but what amounts to a government funded put option that protects the downside. And did we mention that this crop insurance is paid for by the farmer?  Yes, read that twice.

Taken together these idiosyncratic nuances make the odd’s that the company ever experiences a severe/permanent loss of capital extremely unlikely. That, and to marry the best elements of the streaming model with an unheard of measure of downside protection like this was really a stroke of genius. We’ve been attempting to pick apart this puzzle for nearly three months now and our respect for what these guys have done has only deepened every step of the way.

As a quick aside, a big reason the market seems to be missing all of this is because the nature of these seemingly small differences is just not well understood. The fact that Inputs ag model is dramatically less risky escapes the market because most participants are not yet familiar with the unique differences at play here. Honestly, the market is hardly aware the company even exists (more on this in part 2).

Eventually this wont be the case, as the market will realize it’s mistake and come to appreciate the under appreciated virtues of these idiosyncratic differences. Our guess is sooner rather than later given the data from this years harvest is almost in.  Early reports are indicating that 2013 is going to be a very productive year.

Canada + Oil = ?

All that said, let’s take a step back and ask what kind of crop these farmers are growing for Input?  Why, rapeseed plants, of course!  Never heard of it? Yeah, neither had we. Safe to say selling an agricultural commodity with a name like rapeseed is a non-starter but we digress.

Here’s an interesting story.  In the 1960’s, Canadian scientists were looking for a way to grow and process cooking oil.  They succeeded with the rapeseed plant, but quickly realized that no one was going to buy something called rape oil.  So instead, their marketing department took Canada + oil, and came up with Canola! Which explains why you’ve never seen nor heard of a canola plant.

Now, you are probably scratching your heads like we were when we first heard about this.  Canola?  Seriously? But did you know that canola is the most profitable crop for Canadian farmers, constituting 25% of all farm revenues?  In fact over 25% of all the world’s canola is produced in Canada, and 70% of the world’s canola exports are from Canada (can you say cartel?). Regardless, Canola is processed into oil and meal, which is used for cooking oil, animal feed, biofuels, and lubricants.  More importantly, canola is required for long-term food production. In an age where the world’s population is quickly approaching 8 billion and citizens all over the emerging world are introducing more protein into their diets, the fundamental secular tailwinds for Canola are substantial and unrelenting.

What makes this story even more fascinating is that there are over 50,000 canola farmers in Western Canada alone.  Talk about a high margin, borderline absurdly long runway of growth potential (remember we are starting from a base of 10, not 100 or 1000, but 10).  Furthermore, this streaming model could easily be translated to farmers in the upper United States, and farmers of other crops such as grains and pulses (lentils, beans).

Even more compelling is the demographics of Canadian farmers who will soon be undergoing a massive generational transfer of farm assets (over $30 billion) in the next several years.  This is one of the reasons why so many of Canada’s skilled farmers will soon be faced with the expansion opportunities of a lifetime. The rub is that these farmers cannot afford to take advantage of it on their own.

Which leads us to the fact that there is a critical shortage of flexible financing solutions for Canadian Canola farmers.  This is especially true with financing farmers with the requisite working capital to operate and grow their farming assets in the most productive manner possible.  The key to Input’s value proposition to the farmer is that it offers them flexibility and control.  This cannot be overstated enough.  Sure, the traditional bank’s loan may come with what appears to be a lower fixed interest rate, but if you’re starting to run low on cash, the bank is going to come in and force the farmer to liquidate one of his tractors – at the very worst possible time.  Input generates a lot of goodwill with its farmer partners because they will not force the farmer into a corner like this.

In addition, as we stated before, Input will not only give them this flexible capital, but is also committed to help them potentially double their crop yields!  It’s safe to say that no bank loan officer will help the farmer achieve the yields of his dreams.  And this is one of the reasons why farmers are so enthusiastic to partner with Input.  When Input can demonstrate to them how their farm can generate double the amount of crops, it almost does not matter what the cost of this capital is to the farmer.

That in mind, the ideal farmer partners for Input Capital are young capable farmers with the right skill sets but who need capital after purchasing the intergenerational transfer of a farm, or older farmers who foresee a large expansion opportunity, or good farmers who simply need more working capital.  The farms typically range in size from 3,000 to 12,000 acres and are located in the black/dark brown soil zones of Western Canada.

Before we move on then, a couple of things seem clear. One being that canola is a major player in the Canadian economy. And two, despite this fact, canola inexplicably remains largely overlooked by the investment community.

Especially when we juxtapose it with Potash, one of the investment community’s perennial favorites. The point here is to use Potash merely to illustrate the multitude of meaningful similarities between these two uniquely “moaty” commodities with a bevy of structural similarities that make the comparison far from specious.

Consider some of the data points below:

• Canola is a bigger global market than potash
• Canola is a bigger export business for Canada than potash
• Canadian canola exports have been growing at a CAGR of 18.3% over the last 10 years (compared to 13.6% for potash)
• Canola is Canada’s #7 export to the world (potash is #10)
• Canadian canola exports have double the market share in global export markets than potash
• Canadian canola exports to China are 8.5x the value of Canadian potash exports to China
• As already noted, Canadian canola exports to China have been growing at a CAGR of 36.4% over the last 10 years (compared to only 4.1% with potash)
• Canola currently represents 16.0% of all Canadian exports to China (compared to only 1.9% for potash)
• Canola is Canada’s #1 export to China (potash is #12)
• Canola employs 228,000 Canadians.  Potash employs 5,041 Canadians.

Once all that is internalized, consider for a moment that there is only one publicly company providing investment exposure to Canadian canola production: and that’s Input Capital Corp. (TSX.V: INP).  It has a market cap of only $90 million.

Yet remarkably there are three companies providing investment exposure to Canadian potash production: POT, AGU, MOS. Now these are indisputably inferior businesses on pretty much every meaningful level and yet bafflingly, these companies have a combined market cap of essentially $60 billion.

Think about that…

Input’s Owner-Operators: Outsiders in the Making?

The management team behind Input Capital has a history of value creation.  They previously founded Assiniboia Farmland Partnerships in 2005, which was one of the very first private equity farmland partnerships in Canada.,  Starting with $53 million in equity capital, they eventually amassed over 117,000 acres of farmland in Saskatchewan worth over $125 million with over 136 farmer tenants.  The Partnerships produced 20% IRR net of all fees since 2005, returning over 200% to its shareholders.

Through Assiniboia, management was able to form strong farming relationships with their tenants, over 75 of who are canola farmers.  Unsurprisingly it was the trust built through these relationships that helped Input Capital create what your editors view as an amazingly innovative streaming contract on an already innovative business model. Nonetheless, it was this goodwill that provided Input with the customer beachhead necessary to prove out the concept in all its cash generating glory.

Turning to the question of incentive alignment, note that Input’s directors and executives own ~20% of the common stock and are therefore strong aligned with shareholders to create long-term value. As one of Inputs key executives put it, “make no mistake, we’ve got it all on the line.”

Taken together, the above factors point to the fact that we have something special in Input’s executive suite – and by special, we mean owner operators that appear to possess the requisite skill sets and character to build an enduring multi billion dollar business. As you’ll see, these guys are flat out good and their presence at the helm of this undiscovered emerging franchise truly fires us up.

Our calls with CFO Brad Farquhar illustrate this point nicely. For example, Brad has exhibited contrarian, second order thinking on a level that one would think would make Howard Marks proud. Case in point, was the borderline glee in his voice while he explained to us that in his estimation Canola prices were poised to come down in the near term off the back of what has been a record breaking year for Canola farming across Canada. Like a value investor happy to average down on a position in the name of long-term profit, Brad was palpably excited about the opportunity for Inputs terms of trade with farmers to widen in their favor, especially given the ~$45m in dry powder the company is looking to deploy this year.  This might not sound like much, but let’s just say that in our experience, its incredibly rare for an executive to openly root for price declines in way that simply screamed “long-term greedy”. We’d be lying if we said we didn’t love it.

Another illustrative example was when Brad was responding to a myriad of our questions on capital allocation and the paramount importance of preserving/growing per share value.

In particular, while discussing his thoughts on utilizing equity for growth, Brad was emphatic that any future raise would only be considered if it was done at favorable prices (read in a manner that materially augmented per share value). He pointed out that Input had attempted to go public earlier this year.  When their bankers informed them that they had the money but that the pricing would come in lower than what they wanted, they turned it down without blinking an eye. He told us essentially that the decision to walk away wasn’t much of a decision at all and that they would have held out for better terms indefinitely rather than go public merely for going public’s sake.

Another little gem concerning our conversation with Brad, was our discussion of his personal thoughts regarding buybacks. Given the model is one that typically uses serial equity raises (ideally at elevated valuations) in the service of rapidly compounding per share value – and hence is uniquely vulnerable to the empire building CEO – we wanted to know whether he plans on buying back stock in the event of a significant selloff.

This was important in our mind because we wanted to know that whether we find ourselves in a recession – or really any environment that is marked by a steep drop in equity prices – we can count on them to shrink the share count heavily. Remember that the idiosyncratic differences that define Inputs unique model put the company in a unique position to prudently buy back stock in a way that other early stage streamers like SND cannot, a fact that Brad was quick to point out. You see with Input, cash flows are not only highly certain, they are received relatively immediately and therefore can be reinvested immediately. Also given the present valuation, by our math a buyback at half today’s price would allow Input to put that capital to work at higher returns with a fraction of the risk – at least relative to the alternatives uses of that capital (i.e. investing in additional streams).  Clearly buying back stock at a low single digit multiple to pre tax earnings when the equity is worth 10-15x (conservatively) is a very good use of Inputs internally generated cash flow. As they say, the math doesn’t lie. Brad would agree.

And while he prefaced his response by saying that Input was still an early stage (newly public) company, and hence had not “officially” had board level discussions on the topic, he did say that he personally “would be a huge buyer” if the stock were to decline.  And better yet, that as CFO and co-founder of the world’s first agricultural streaming company, he understands the “cash-generating power of the business better than anyone else alive.”  He emphasized that in this scenario “buying back our own stock is the best thing we could do”.

Input’s Breakthrough Value Proposition Quantified

Editors note: Part of our due diligence process consists of designating various members of the team and trusted colleagues with the task of devils advocacy with every idea under consideration. Below is a few questions that we felt were particularly thoughtful in this regard. Our hope here is that by answering these questions they will provide members with not only some hard won insights, but also a springboard of sorts for readers to write us with their own questions and concerns. So, with that lets dig in…

Q: If these deals are so lucrative, why then doesn’t everyone do it? What’s behind this, is the issue capital constraints, awareness, or belief in the efficacy of methods / fertilizer etc.?

A: Everybody isn’t doing it for the same reasons that most investors invest like idiots, they don’t know any better and even if they did, it would take a substantial sum of money and many years to ramp the learning curve. Input is a business that was created and fine tuned over many years. It is not something that can be replicated with a big pile of cash.  And it relied heavily on their pre-existing relationships with the farmers that lease out their farmland from their farmland partnerships.

Sometimes, a great idea can be staring at you in the face, but if it’s difficult to implement, then it won’t get done.  For example, a lot of investors in the last decade believed that farmland prices were going to skyrocket.  We even thought so too.  But did we buy any farmland?  No . . . because it’s really hard!  There’s no farmland equities traded on a liquid financial exchange.  There’s no futures on farmland.  Even if we went out and bought some land personally, we’d then have to grow the crops ourselves or lease it to some farmers and manage it.  Farmland had not been “financialized,” and therefore very little institutional money went into it.

But Brad and the Input Capital management team did.  They had the thesis right, and then walked the walk by creating a series of private equity farmland investments.  And that’s what they are doing here with Input Capital.  It’s not just a matter of coming up with the capital.  They had to have the right relationships – with the farmers, with the agrologists, with the grain elevators, etc.  And these relationships were earned through trust developed over many years.

What Input does is so powerful because they give a farmer the financial tools he needs, the agrologists give him the information, the science and the coaching he needs – so that the farmer just needs to go out and execute. And assuming average weather, he’ll do better than he has before. All because the marginal return on the next dollar of inputs is astronomical, and he’s not “going at it alone” – and hence likely to make a fatal mistake in an area where he may be a little out of his depth.

That, and it takes money to make money. If you don’t have money, you might succeed by pulling yourself up by your own bootstraps over time. But wouldn’t it be easier to take on a financial partner who will put in equity-like capital and take it out on a predictable schedule over six years? Of course it would be, and that is what Input does. It brings the best of everything together.

Q: From a secular perspective, the AG industry in the U.S. has gone industrial with a sophistication and scale that is dramatically higher than just 10 years ago.  Is this not the case in Canada? In other words, why isn’t the canola market as sophisticated as say corn in the U.S? The reason we ask this is that one would imagine a large, sophisticated farmer would figure this out and keep all the incremental margin for himself. What’s the deal here?

A: Our understanding is that things have gotten way more sophisticated. A typical grain farm needs 5,000 acres to get scale. Some of Inputs clients are much larger than that. But these new technologies – variable rate tech, GPS, precision agriculture, etc. etc. – are just coming into maturity for what Canadian’s grow and how they grow it across Western Canada.

For these reasons, we believe the next 10 years should be an unbelievable time for Canadian farmers as tech and soil and seed science converge, but it is indisputably  more capital intensive than it’s been in the past. Those with the capital will succeed, and those who don’t will be hobby farmers.

Even large, sophisticated farmers are struggling with the capital requirements of farming today. Land is way more expensive than 10 years ago, equipment is bigger and more expensive, labor is more expensive, inputs are more expensive, and the scale is way more massive. The improvements in potential results outweigh all of this, that is if you have the capital to unlock the productivity potential.

As we understand it then, everyone would love to do it if they could, but again, the tools available to the vast majority of farmers today in Western Canada are limited and inflexible. What Input Capital offers is much more material to a farmer than what their banker has to offer, and much more flexible than what their trade credit supplier has to offer.

So again, Input’s main benefit is that their financing of working capital is non-constraining, flexible, and therefore gives farmers control which allows them to be very opportunistic and provides them with the requisite freedom to make the right decisions economically long-term.

Sadly, often times farmers make decisions not based on best economic long-term outcome, but according to their opportunities as they become available, which is often when they are most starved for capital and hence maximally vulnerable. And even in flush times when they do have money they will invest, but then in an ironic twist of fate, that will only leave them tightly constrained and in a poor position the following year, especially if things get worse. For example, if it’s a great year this year, a farmer may take the cash and purchase the farm next door to expand, but then this leaves them tightly constrained with a lot more land but essentially no working capital to make that land productive in a maximally efficiently manner.

Another example of how truly priceless a relationship with Input can be gleamed by looking at what happens to a farmer if sometime in the future he has a horrendous year for whatever reason. In this case, Input can allow the farmer to roll over the promised base tonnage into the next year, so that the farmer isn’t put out of business. Obviously Input’s flexibility generates a lot of goodwill compared to other kinds of bank financing.

In sum, Input helps farmers drive down their cost of capital through productivity improvements and various cost savings, all of which is quantified below:

1. Buying inputs off season (~20-40%)

2. Discount for Paying Cash (~3%)

3. Interest Costs (~10%)

4. Flexible Crop Marketing Program (~6-12%)

And these are just a few of the ways Input is able to help farmers unlock their productive potential. The fact is, this isn’t just some clever slogan, as Input is able to reduce a farmer’s inherent cost of capital on average by a whopping ~39 – 65%!!

What’s Input Capital Worth?

Current Price: $1.60

Shares Outstanding: 59.0m

Market Cap: $94.4m

Fully Diluted Shares: 62.6m

Cash: ~$37m

To get an idea of what Input is worth, let’s crunch some numbers to get a feel for the cash generating power of the business assuming the company deploys its existing war chest at similar returns of some of the company’s more recent deals. Lets also assume no further equity financing between now and year-end 2014.

We use YE 2014 only because the company should begin to receive the high margin cash flows derived by putting to work the tens of millions presently sitting in cash on Input’s balance sheet.

At any rate, a great way to accomplish this (we think) is to use the last deal Input inked in Alberta for guidance. With that deal we saw Input pay $1mm upfront for a 6 year deal in which the farmer will sell the company 888 tonnes of canola per year, for six years, at a predetermined and heavily discounted price of $100 per tonne.

So, if we take the $35m from Input’s most recent capital raise plus the $5 to $6 million in FCF the company should generate both this year and next, that gives us a range of something between $45 & $50m in available capital for reinvestment before we account for any bonus tonnage.

So 45 x 888 equals 39,960 tonnes on the low end. If we user the higher end of the above range, we get 50 x 888 or 44,400 tonnes. Add the mid point or ~41,880 to the tonnage Input is already set to receive this year from its streams already in place – which is another 17,152 tonnes (give or take), and we are looking at a total of approximately 56,032 base tonnes as a reasonable basis for projecting the company’s earnings capacity come year end 2014.

Also, according to management, it’s reasonable to assume that these new tonnes will have a $100 delivery payment just like the 888 tonne deal noted above. Given that, we should be able to forecast Input’s “normalized” earnings power in future years in a manner that is at least approximately correct. In other words, we have all the secret ingredients necessary to derive our estimate.

So, assuming a net profit of $400 per ton (a number we derived simply by taking our $500 “mid-cycle” or “normalized” estimate for the price of canola minus Inputs $100 purchase price/bushel), the company would generate ~$22.4m in cash by year end 2014.

Being a small company with a model characterized by low fixed costs, Input’s expenses are very low – currently only about $1.2m per year.  Let’s assume that this will double to ~$2.4m as they will likely be hiring a couple of sales/marketing people and be spreading the word about Input to more farmers.  In that case, Input’s pre-tax cash flow will approximate ~$20m.

Now if that number doesn’t make you want to “rub your eyes and check again” something is seriously wrong. After all, that means investors are getting a chance to purchase Input today at a mere 5x pre-tax cash flow.

Remember as well that this is BEFORE we’ve taken into account the value that will likely accrue to Input based on the value of its bonus tonnes related to it’s own forecasted yield improvements. The funny thing is, based on early indications this number is looking to be very significant but of course we will have to see.

Ok, well, what about if we include “performance fees” in our assessment? What’s our implied YE ’14 multiple to pre tax cash flow?

Great question! If we want to try and back into what we’re paying if Input delivers on its claims as it relates to its ability to dramatically improve the productivity of its partner’s farms, shareholders will be very happy campers. The thing is, to do that investors need to realize that for every 10 bushel per acre yield increase over the 30 bushels per acre hurdle, Input stands to benefit to the tune of about an 8% increase in total tonnage received.

What’s interesting is that our understanding is that Input’s farmers could quite possibly hit 50 to 60 bushels/acre, or at least something close to it without too much trouble. Indeed, one can look at a variety of examples from this years harvest (according to management) and conclude that is a number that is very possible. Of course until the imminent release of the data from this years harvest we can’t say for sure, but all indications lead us to believe that such an estimate isn’t aggressive.

Regardless, according to the anecdotal evidence from this years harvest it appears shareholders have multiple reasons to believe Inputs average streaming partner will manage to improve his bushels per acre metric to something close to the 60 mark hypothesized above. If that proves true, Input would earn additional bonus tonnes of ~13k tonnes or approximately $5.3m for the year. And again, if the data proves this out, it’s not unreasonable to assume these performance fees will repeat over the life of the streaming contract. Sure, 2013 was the best year on record but these yield improvements have presumably been driven by Input specific initiatives and hence, are more likely than not to be sustainable.

If that’ the case, an upside estimate of Input’s “true” annual pre-tax cash flow come year end 2014 should clock in at ~$25m. This would obviously make the base case owner earnings multiple we derived above even lower. In other words, by our math investors who get in at the current trading price could be paying an implied 4x YE ’14 pre tax cash flow. 

Now that’s the type of valuation on an undiscovered emerging franchise that gets your editor out of bed every morning!!! And with that, we’ll leave the rest for part 2 coming later this month.

In the meantime, feel free to email me with any questions and rest assured we’re just scratching the surface of this remarkable opportunity.

Until then!

To kick things off right, I’ve included long-time friend of the blog Adam Patinkin’s latest letter to partners. Adam is a CFA Charterholder and is the Founder and Managing Member of David Capital Partners, LLC (“David Capital”), based in Chicago, IL.  Prior to founding David Capital in late-2011, Adam was a member of the investment team at Sheffield Asset Management, L.L.C., a $500M long/short equity hedge fund. At Sheffield, he was responsible for sourcing and evaluating investment opportunities in public securities and commodities markets on a global basis.  Adam specializes in cyclical industries and businesses undergoing substantial structural or competitive change. His equity investment experience covers a wide range of sectors and is augmented by significant work involving commodities, credit, derivatives, and special situations.

I’ve had the pleasure of knowing Adam for a few years now, and in my opinion he is about as brilliant and incisive an investor as there is.  Adam launched his fund with $2M in assets in late-2011, and in about 2.5 years he’s grown it to more than $20M – which speaks to his talent, top notch analytical abilities, and a fund almost certain to have a very bright future.  At 29 years-old, we think he’s a “rising star” in the value world/hedge fund community.

Adam’s quarterly letters usually provide an in-depth write-up on a single investment idea, but in his latest missive he switches gears to share his thoughts on the broader markets.  Adam has generously allowed us to republish his commentary on AAOI (we unfortunately are unable to publish the rest of the letter, including performance metrics, for compliance reasons).

I think it’s a great read and a wonderful way to re-launch the site.  At any rate, we look forward to sharing Adam’s thoughts again in the future (you can count on it) – David Capital is without a doubt a fund to keep an eye on!

Enjoy!

David Capital Partners, LLC – 2013 Q4 Macro Commentary FINAL

Berkshire Hathaway shareholders from all online communities are welcome to an unofficial gathering on Friday, May 3th, 2013.

You are invited to join as fellow shareholders unofficially gather on Friday, May 3th, 2013 at the DoubleTree Hotel in Omaha to meet and have fun, starting at 4:00 pm and you can linger until 7:00 pm (or longer). There will be a short program at approximately 5:00 or 5:30.

This is a casual atmosphere, with light snacks available. It’s a “happy hour” type of gathering – not a formal dinner or anything of that sort.

The DoubleTree is located on 16th and Dodge. There may be some street parking, otherwise, one can use the parking garage with an entrance from the South at 16th & Dodge street, just east of the First National Bank.

To register for the event: http://yellowbrkers.com/

Action to take: Buy Jamba Juice (JMBA) up to $3.00 per share.

Target: $8.00-10.00 per share over 3-5 years

Synopsis: Jamba juice presents an opportunity to purchase a high quality owner operated compounding machine at a mid single digit multiple of YE 2013 owner earnings. With a current enterprise value of only ~$180m investors can purchase the company’s owned store base at a sizable discount to true value and get a bevy of high margin, annuity-like recurring revenue streams from their franchise and royalty segments for free.

“The best business is a royalty on the growth of others, requiring little capital itself.” — Warren Buffett, 1978

I was six years old when I first started to learn the wisdom of these words (Eugene here).  My parents had just decided to pursue the American dream of owning their own business.  My father was making a modest living as an entry-level engineer at Mobil (before it became ExxonMobil), and my mother taught math at the local community college.

They had immigrated to the United States from China for their graduate studies, and over the years had scrimped and saved every dollar they possibly could.  So in 1982 they took their entire life savings of $150,000 and opened a small electronics retail store in the local shopping mall called Team Electronics.

Team Electronics operated as a franchise model. My parents were the “franchisees,” the owner/operators of their own individual unit store.  This means that they took their own capital and built and operated the store. Team Electronics the parent company was the “franchisor” and provided the business template to my parents: training, suppliers, advertising, etc.

In return for these services, Team Electronics the parent company would get paid a royalty fee of 6% of all sales.  In return for their hard work, my parents would earn a profit of whatever’s remaining after this royalty fee and all other operating expenses were deducted.

And what hard work it was.  Every waking hour of every day was spent dealing with retail customers, managing employees, escalating rents, learning accounting, tracking inventory, etc.  On weekends I would earn 25 cents for cleaning the store toilet.  On a Friday night after working until 4 a.m. my parents were too exhausted to safely make the drive home, so we stayed at the La Quinta motel across the street.  The next morning we had to be back at the store at 9 a.m. to open.  After many years of extremely hard work, my parents eventually parlayed this rocky start into a successful business and realized their American dream.

It didn’t take me long to realize that it was a much better business proposition to be the franchisor than the franchisee.  For example, in the early years our store might have annual sales of $500,000.  After paying all the expenses, my parents were lucky to take home $20,000.  Based on their initial investment of $150,000, they were earning a 13% return, which doesn’t sound too horrible.  But remember, that’s after risking their entire life savings, both working over 100+ hours per week, taking on all the risk of purchasing inventory and long-term lease obligations, not to mention the stress and headaches of running your own business.

As the franchisor, Team Electronics the parent company would earn about $30,000 (6% of annual sales of $500,000) from my parents’ store.  What did they risk to earn this $30,000?  Almost nothing.  They had already developed the business model template, so all they had to do was provide a few weeks training to my parents and some occasional support.

What if my parents’ store had a bad year and only sold $400,000 of electronics?  My parents would pray to break even, but Team Electronics the franchisor would still earn $24,000.  In other words, to earn this perpetual income stream of $24,000 to $30,000, Team Electronics the franchisor undertook no risk, and invested almost no capital.

Warren Buffett captured a powerful insight in just a few words: “The best business is a royalty on the growth of others, requiring little capital itself.”  Indeed!  It would be almost 25 years later when I first read this nugget of wisdom by Buffett.  But then again I didn’t really need to, because it was already firmly etched into my mind from cleaning toilets.

Framing the Opportunity: The Power of the McDonald’s Franchise Model

Imagine for a moment that you could go back in time and buy a piece of one of the all-time great businesses in the world: McDonald’s (MCD).  Imagine that you could go back to 1968 when it had less than 1000 restaurant locations, before it’s explosive growth to over 33,000 units today.  What makes McDonald’s such a great business?

It has an extremely strong brand and mind-share across the globe. Three times a day at every meal is an opportunity for McDonalds to generate income from almost the entire world’s population.

An equally important reason for McDonald’s business success is its franchise business model.

McDonald’s gets a continuously recurring stream of income from every single item of food consumed in each of its 33,000 restaurants around the world, 365 days a year. From every Coca-Cola that you buy for $1.80, McDonald’s (the franchisor parent company) receives over 20 cents (McDonald’s royalty is 12% of sales).  It’s a business model that is superior even to Coca-Cola itself.

McDonalds’s is truly one of the greatest perpetual annuity income streams in the world.  It is a very low risk, capital-light business model generating income from the sales of each franchisee.  This franchise model virtually ensures that McDonald’s will always generate a profit, regardless of the economy or fluctuating food sales.  In some ways, it’s more akin to a utility in the stability and predictability of its cash flow generation, versus the ups and downs you would find in a typical restaurant business.

Let’s examine a critical phrase from Buffett’s quote, “ . . . requiring little capital itself.”

Given the nature of the franchise model, the vast majority of McDonald’s profits can flow down to the benefit of the shareholders (via dividends, buybacks, or reinvested for growth), without impairing it’s competitive position or future earnings capacity.  This is because the franchisees, like my parents, are on the hook for all of the negative aspects of the business: escalating expenses with inflation, large capital expenditures required just to maintain the physical assets, etc.

All of these negatives consume capital, reduce profits, and make it difficult to grow the business.  Not only do the franchisees bear the weight of having to continually reinvest capital back into the business just to keep it running, but they must also invest all of the capital required to open additional locations.

On the other hand, McDonald’s the franchisor is a much more attractive business because it is not required to expend its capital on these negatives.  It may choose, however, to reinvest a small portion of its profits towards creating a stronger brand.  By doing so, McDonald’s can increase sales at existing locations and encourage growth through franchisees opening new locations.  Thus, the franchise business model creates a strong virtuous cycle of an ever-growing royalty stream of cash, requiring little capital itself.

Another important element of the franchise model is the lack of negative operating leverage.  Negative operating leverage is bad: if sales drop by a few percent, then profits will drop by a much greater percentage.  This is usually due to the burden of large fixed costs required just to stay open for business.

For an example, let’s return to my parents’ small retail electronics store.  In an average year, the store would generate $500,000 in sales, with a gross profit of $200,000 (i.e. 60% cost of goods sold, or a 40% gross margin).  Their fixed costs such as rent, utilities, and employees would be about $180,000.  So, they would be left with a net profit of only $20,000.  Heaven forbid if they had a bad year with sales declining 20% down to $400,000.  The 40% gross margin would then yield a gross profit of only $160,000.  But their fixed costs would remain about the same at $180,000, wiping out all their efforts and resulting in a net loss of $-20,000.  That’s negative operating leverage at work.

Conversely, the franchisor parent company does not suffer from this business problem.  Because it always gets its 6% royalty of sales, it doesn’t matter whether sales were $500,000 or $400,000.  At worst, the franchisor would still generate a profit of $24,000

One last salient point we want to highlight about the superiority of the franchise model is the divergent effect of inflation on the franchisee versus the franchisor.  Buffett alluded to this during the 2011 Berkshire Hathaway annual meeting: “Ideally to protect against inflation, you want a royalty on someone else’s sales so you don’t have to invest any more capital . . . you make money as their volume grows.”

Rising food costs from inflation generally hurts the franchisees operating the restaurants because it crimps the profit margins.  Soon, inflation will force the franchisee to raise prices simply to maintain the same nominal level of profitability.  However, in a perverse twist of economics, what is the franchisee’s pain ultimately becomes the franchisor’s gain.  Because the franchisor receives a fixed percentage of the top line food sales, these price increases will fall directly to the bottom line resulting in higher profits.  In other words, inflationary forces will provide a perpetual tailwind of rising profits, instead of a continuous headwind depressing profits.

What if my parents had invested their $150,000 life savings, not by becoming a franchisee of Team Electronics, but instead by buying stock in the franchisor McDonald’s?  What if they could have bought it in 1968 when McDonald’s had just opened its 1,000th store?

In many ways, this would have been a very low risk investment. By then McDonald’s franchise business model was already perfected by Ray Kroc, was geographically diverse, and was very profitable.  It did not require any unusual creative foresight to see the potential runway of growth.  Indeed, the potential should have been self-evident if only they had fully understood the power of the franchise business model at that time.

Well, it pains me to say that my parents would now be worth over $35 million, and I wouldn’t have had to clean any toilets.

So the question some of you may be asking is: if McDonald’s is so great, why not buy McDonald’s stock now?  Well, it’s already a $100 billion company.  While there’s always some room for growth, the tailwind is not nearly as great as it was 40 years ago.  Also, the stock is not an extremely cheap value, trading at about 18x earnings.

What we want to find is the McDonald’s of 1968: a wonderful business with similarly attractive economic characteristics, set to ride a tidal wave of growth over the coming decade, trading at a very cheap price today that does not factor in any of its enormous potential.  And that, dear readers, brings us to this issue’s recommendation: Jamba Juice (JMBA).

The Jamba Juice Turnaround

(Pic)

Flying low under the radar of Wall Street, Jamba Juice has executed a remarkable transformation over the last four years to become the ideal franchise business model.  Today it is on the cusp of becoming a huge global brand riding the tailwind growth trend towards healthy active living.

Despite relatively few stores (780 units) and low geographic market penetration, Jamba enjoys extremely strong brand recognition, consistently ranking high in association with a healthy active lifestyle, similar to brands such as Whole Foods and Chipotle.  The nearest Jamba Juice to my home is several hours away, yet all of my neighbors have heard of the brand and associate it with healthy fruit smoothies, even though they’ve never actually been to one of the stores.

While many people recognize the Jamba brand, the stock has been completely ignored.  It is a microcap with a market cap of only $200 million. As a publicly traded company, Jamba has had a poor showing for much of its history.

Jamba became public in 2006 as the leading concept store selling fresh fruit smoothies with ambitious plans for growth.  However, its business model at that time was your typical capital-intensive fixed-cost restaurant.  Over 70% of the locations were company owned and operated, and less than 30% were franchised.  In a misguided attempt to grow 30% annually, many operational problems immediately began to surface.  Profit margins at the company-owned units declined from 20% down to below 10%.  Rather than grow, the sales at each store actually declined 8%.  Soon, the company posted losses of $150 million (a lesson in the perils of negative operative leverage).  Within two short years, the stock imploded from $12 to pennies.

In late 2008, Jamba Juice began one of the most remarkable corporate turnarounds we’ve ever witnessed.  First, to avert terminal cardiac arrest the company raised $32 million of cash through a preferred stock issue, bringing some much needed financial stability.  Second, in December 2008 they brought on board one of the best CEO’s we’ve ever seen: James White.

Previously, White worked with one of the greatest executives in the corporate turnaround game, Jim Kilts who orchestrated Gillette’s spectacular success.  Later, White became a brand builder by developing the consumer-packaged goods (CPG) business within Safeway, responsible for brand strategy, innovation, manufacturing, and sales.

Jamba hired White for his skills both as a corporate turnaround specialist for the near-term, and as a brand builder to help drive growth for the long-term.  White is a CEO who is not flashy and does not oversell.  He intensely focuses on the “Plan,” and more importantly, the solid execution of the plan.  Since 2009, this management team has literally made all the right strategic moves, and executed them with remarkable speed and effectiveness.  Let’s take a closer look at some of them.

White’s first order of business was to restore the business to profitability.  If a business is not profitable, over time it will bleed cash and eventually go under.  White had to make the difficult decision, as CEO of a newly public company, to give up on growing revenues for the sake of improving profitability.  Wall Street hates declining sales, and while obviously the correct long-term decision, it can be a painful transition in the short-term.  White’s game plan was to gradually transform Jamba to become a franchisor, because he recognized it was such a vastly superior business model.

To make this transformation, Jamba Juice started to sell many of their poorly performing company-owned stores to franchisees. These poorly performing Jamba Juice units generate less than $500,000 in sales (the better performing stores which Jamba kept generally average more than $700,000 in sales).  By refranchising this store, Jamba would give up these “revenues,” but in return it would get $30,000 (6% royalty fee) each year.

As a franchisor parent company, this $30,000 would be the new number that Jamba would report to Wall Street as revenue.  While much lower, the important point is that this is nearly all profit.  In the process of this conversion, Jamba would sell these units to a franchisee for an average of about $215,000.  With this kind of transaction, White simultaneously killed two birds with one stone: convert a money losing asset into a cash generating machine, and immediately raise some cash to help keep the company afloat.

For the franchisees, they would be getting a Jamba unit a great price.  On average, it takes about $500,000 to build a new Jamba unit from scratch.  So by purchasing this existing unit from Jamba for $215,000, the franchisee got a great deal and is off to a good start.  It’s a mutually beneficial transaction.  It is also encouraging to see that many of these franchisees that bought the units from Jamba were already current Jamba franchisees – signaling that they believed in the strength of the brand and the turnaround efforts.

White’s goal is to eventually make the transformation so that about 80% to 90% of its stores are franchised, and 10% to 20% would remain company-owned (as of today, almost 60% are franchised).  In the depths of 2009, however, over 70% were company owned.  Therefore, White also had to simultaneously focus on restoring profitability at the company owned units.  Within a short period of time, White improved same-store sales, reduced the cost expense of food supplies, reduced the cost of labor, and dramatically improved profit margins.

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If all that wasn’t enough, Jamba also desperately needed to diversify away from smoothies.  Selling only smoothies carried many drawbacks.  It concentrated the majority of sales within a narrow window in the afternoon, which caused operational and throughput inefficiencies.  So, the strategy was to create high-quality food offerings that would help drive sales throughout the entire day.  Jamba’s first offering was an award winning steel-cut oatmeal, which was a great success.  Jamba soon expanded to offering wraps, flatbreads, and kid’s menu items.

Growing the Brand Beyond Just Juice

Within three short years, Jamba has transformed its core business from an unprofitable one-trick pony, into a complete quick service restaurant alternative with an extremely strong niche brand associated with healthy active living.  The company has also converted to a highly profitable low-risk capital-light franchise business model.  And the really great news is that Jamba has barely gotten started.  Its goal is to become the leading health and wellness brand in the world.  With the turnaround completed, Jamba can now focus on growing its brand.  Let’s look at some of their strategies and initiatives to illustrate why your editors are so excited about the company’s plans and long-term potential.

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Consumer-Packaged Goods: Jamba is extending their brand into every Wal-Mart, Costco, grocery, and convenience store near you.  They are partnering with other companies to develop products such as smoothie kits for home, frozen yogurt bars, trail mix, and energy drinks. These deals are very favorable for Jamba in that they are similar to the franchise royalty model. Jamba gets paid a licensing fee of 3% to 5% of every sale.

Jamba offers their brand name and helps develop the product and marketing.  The partnering companies will be responsible for all the heavy lifting including production, packaging, and distribution.  In other words, the other companies will carry the burdens of fixed-costs, capital investments, and managerial responsibilities.  Jamba simply sits back and collects checks.  Jamba’s expenses for developing and growing this operation are very low – basically just a handful of employees.

Sales growth within this nascent segment has been phenomenal.  Jamba started with home smoothie kits, and sales in 2010 were only a few million dollars. This grew to $50 million in 2011, and is estimated to be $150 million for 2012.  Within a couple more years, this should easily be a $500 million to $1 billion business. Remember that Jamba will get at least 3% to 5% of every sale, and this revenue stream will be almost entirely pure profit.  With a market cap of only $200 million, to say the math is extremely compelling is quite the understatement.

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JambaGo:  There is a movement afoot to ban sugary soda like Coke and Pepsi from schools.  It is also a public health concern that kids aren’t getting enough fruits and vegetables, and they certainly don’t like eating what the school cafeteria cooks up.  So who are the tens of thousands of schools across the nation going to turn to for a solution?  Why Jamba, of course!  In fact, Jamba has developed a standalone unit called JambaGo specifically to be installed in schools.  These units blend fresh fruit and non-fat milk to create a healthy but tasty option that kids will actually eat.

The growth has been stunning.  JambaGo is a hugely value-add product that sits squarely at the center of an emerging and growing secular trend.  Jamba started with a few schools in 2011, and grew to over 400 schools by end of 2012.  Management’s stated goal is to have JambaGo in over 1500 schools in 2013.  The potential growth runway for this concept alone is mind-boggling.  Jamba has not penetrated even a fraction of a fraction of the addressable market.

In the United States alone, there are over 100,000 K-12 schools, over 100,000 convenience stores, and over 5000 colleges and universities.  We estimate that each JambaGo unit can earn about $2,000 to $3,000 per year for Jamba.  The economics are very favorable, again, because JambaGo does not require any capital investment from Jamba. The schools pay for and operate the units.  So virtually all of this revenue will be pure profit.

Even more compelling than the economics, is the branding and goodwill that JambaGo can build for Jamba.  Imagine being in front of every kid every day for lunch, and providing the best-tasting menu option available in the cafeteria.  No amount of advertising dollars can buy this kind of brand awareness.

Jamba has many other promising initiatives in development as well.  Management is being highly selective about the location of new store units.  Prime locations will be in airports, universities, and business areas like convention centers.  Each store will then have the highest impact and exposure to the broadest population.

Jamba is developing a smaller format “Smoothie Station” store unit for convenience stores and entertainment venues.  The company has also expanded their product offerings into energy drinks by partnering with Nestle, and into premium hot teas by acquiring Talbot Teas.  Jamba is starting to offer fresh squeezed juice at their stores to capitalize on the juicing craze.  (By the way, this juice bar upgrade has been extremely impressive: for an investment cost of $50,000, this upgrade has generated same-store sales growth of 50% to 100% per store!)

At several locations, Jamba is starting to add drive-thru’s in order to provide faster service and convenience, which will especially help drive growth in geographic areas that aren’t blessed with California weather year-round.  Jamba is also actively engaging the community, such as developing a relationship with the school PTA, to promote health and wellness.

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The Jockey

This remarkable transformation is why we say say that James White is hands down one of the best CEO’s ever.  Years from now we believe that case studies will be written in business schools about how White orchestrated Jamba’s turnaround and laid the foundation to build an enduring global brand.  This is the kind of management team that you want to partner with for years to come.  Within three short years, they took a one-dimensional smoothie shop with $150 million in losses, transitioned this core business to profitability, and simultaneously developed multiple new lines of low-risk, capital-light, high-growth initiatives.

When evaluating management, I usually consider two things.  First, did they do what they said they would do?  Check out this extended video from three years ago when White first started at Jamba.  In clear simple English, he laid out his entire plan and future strategy.  It’s almost an hour long, but very well worth it, as you will come away with a deeper understanding of the company and how White operates.

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So we can now verify that White did indeed execute his plan in brilliant fashion.  Here we have a CEO who ends all of his presentations with the mantra “Promises made will be kept!”  How refreshing!  Rarely have we seen this level of accountability and execution from a CEO before.  Here’s an episode from Bloomberg Television where White is a mentor to another business owner.  Notice at the end, his advice boils down to “It’s all about the plan.”

http://www.bloomberg.com/video/65330968-bloomberg-the-mentor-james-white-guides-drybar.html

Second, does management have any skin in the game?  Do they own a lot of stock options or restricted stock?  Better yet, did they take their own cash and buy shares in the open market?

When White joined Jamba in Dec 2008 as CEO, he was granted a special package of 1.5 million stock options.  Additional options have been granted over the last three years as incentive compensation and bonuses.  More importantly, White has invested over $250,000 of his own cash buying stock in the open market at periodic intervals between $1.02 and $2.01 per share.  While this may not seem like a lot of money if you’re a Wall Street bank executive, it is a very significant purchase relative to White’s after-tax income (annual salary: $550,000).

How Huge is the Potential Growth?

Let’s take a moment to recap here.  We have an opportunity to buy shares of Jamba Juice, one of the strongest brands in the country riding on the growing trend towards healthier eating and living.  Jamba has recently completed a remarkable transformation into one of the greatest business models of all time: royalty fees from franchising and licensing.  The business possesses highly attractive economics with its diversified set of sticky, stable, high-margin revenue streams.  In addition, future growth requires very little capital investment, and thus carries little risk.  Most importantly, this is a low risk investment because, unlike other turnaround stories, we can buy this turnaround after it has already been completed.  Plus, Jamba now has $30 million in cash (over 40 cents per share), zero debt, is cash flow positive, and is headed by an exceptional CEO and management team.

Now let’s consider the future.  Jamba is starting from a low base of 780 store units, and management plans to open about 50-70 new franchise units per year.  Management has stated in presentations that it believes the potential number of store units is 3,700 globally.  We believe that this is vastly understated.  This is the same estimate they used five years ago, and the Jamba brand has certainly grown stronger since.  Of the 3,700 units, about 1,000 are suppose to be international stores.  This is certainly underestimated, as there are plans for 200 units within South Korea alone.

We don’t know exactly how many units the future will hold, but we are highly confident it is well above 3,700.  For frame of reference, McDonald’s has 33,000 locations, Starbucks has 20,000, Burger King has 12,000, and Wendy’s and Dairy Queen each have about 6,000 locations.

While Jamba will never have as many locations as McDonald’s or Starbucks, we think that 5,000 to 6,000 units are definitely possible.  That is more than 6x the current footprint.  Add to that, the royalty fees from the consumer-packaged goods business with multibillion dollar potential, and exponentially growing revenues from JambaGo that will soon be in thousands of schools, and it should start to become very clear that the estimates don’t even scratch the surface of Jamba’s ultimate growth potential.

The great thing about Jamba’s growth runway is that its huge potential is not just theoretical.  It has been demonstrated and proven over the last three years.

Why is it Mispriced?

And the best part of all?  Wall Street has not taken any notice . . . yet.  This microcap with a checkered past has historically reported losses, and its transformation has been under Wall Street’s radar.  As it’s been working through the turnaround, these losses have been rapidly declining.

The primary reason why Jamba’s underlying highly attractive economic characteristics have remained hidden is that the corporate level general and administration expenses are relatively high ($38 million) for such a small company.  This has been a deliberate decision because White wants to maintain a strong platform that can easily scale and accommodate the anticipated future growth.  In addition, this was used to lay the foundation for developing the consumer-packaged goods and JambaGo businesses.

We love situations like this where the stock’s value is obscured from cursory screens, and some extra effort is required to peel back the layers to uncover the gem.  On this point, we will quote from the always fantastic letters of East Coast Asset Management’s Chris Begg:

“ . .The market is less efficient in its ability to look around the corners for businesses that are not yet great, but emerging toward greatness . . we are focused on seeking knowledge of the causes that will produce a meaningful inflection point of change on the economics of the businesses.”  

(Christopher Begg, East Coast Asset Management, Fourth Quarter 2012 Update)

Exactly!  Jamba is rapidly nearing its inflection point.  With Jamba’s expansion and growing cash flows, it will soon achieve enough scale where the corporate level expenses become a much smaller component and no longer mask the underlying favorable economics of this business.  Stay tuned for future updates where we will examine in-depth the power of this hidden fulcrum and how it will soon flow through the underlying business into financial statements.

We expect that when Jamba reports its financials for 2012, it will likely report a profit for the first time.  This will start to attract attention from the institutions.  With the turnaround recently completed, White has been doing more CNBC interviews and emphasizing the company’s plans for growth.  Your editors believe that 2013 will be the year when everyone starts to take notice of Jamba’s remarkable business.

Just How Cheap is This Stock?

Today, you can buy all of Jamba’s stores, transformation, brand name, and future growth for an enterprise value of $180 million at $2.70 per share (enterprise value means the price to acquire the entire business: market cap equity plus debt less cash).  For such a strong consumer brand with so much future potential, that is just dirt-cheap.

FY 2013 Run-rate Estimates

By the end of this year 2013, Jamba should be on track to generate almost $40 million in free cash flow in a normal year going forward.  For a high quality capital-light business like Jamba with plenty of growth ahead, it should deserve a valuation multiple of at least 10x (likely higher at 12x to 14x).  Assuming 10x Jamba would be worth about $5.00 per share, or almost 100% upside from today’s price.  To put it another way, the present valuation stands at less than 5x our estimate of 2013’s year-end normalized free cash flow.  Again, this is just way too cheap no matter how you slice it.

Let’s look ahead three years including some reasonable estimates such as 4-5% same store sales growth, adding 70 new franchise units per year, and growing the consumer-packaged goods business and JambaGo.  Jamba should be able to generate pre-tax cash flows of $70m, and should be worth over $8 to $10 per share – that’s 300% upside in three years.  In future updates we will show in detail how the growth of each of these segments will translate into rapidly rising cash flows.

Even better, we believe that this huge asymmetric upside carries relatively little permanent downside risk.  Jamba is cash flow positive, has zero debt, and has $30 million in cash (over 40 cents per share).  Jamba’s turnaround is already complete, the growth strategies are already proven in the marketplace, and you couldn’t ask for better management.  Finally, its high-margin, capital-light, business model of franchising and licensing helps ensure that the company can remain profitable and survive any economic downturns.

Just for kicks, let’s consider the future value of just one of the nascent hidden business segments.  The sales of the consumer-packaged goods business is expected to be over $150 million for 2012, triple the sales compared to the year prior.  For 2013, management has guided for sales of $250m, but we think that this is severely understated.  We believe that within a couple of years, this segment should generate about $500 million to $1 billion in sales.

Assuming that Jamba gets a 3% licensing fee (also likely on the low end) of $500 million, that’s about $15m of almost pure profit.  This is a very reasonable estimate since management has stated a goal of $15m by 2016.  Indeed, it may prove very conservative, given management’s long history of under promising and over delivering.  Given its secular growth and high-quality capital-light characteristics, the CPG segment should be valued at least 12x, or $180 million.  You read that right – in a couple of years, this one obscure segment alone will be worth more than the entire enterprise value of the whole company today!

We could also run through a similar exercise with the JambaGo segment.  Or consider just the royalties from the franchised units.  Or we could even casually mention the fact that these kinds of asset-light cash-flow generating companies can afford to lever up their balance sheets.  Jamba could easily accommodate some modest debt and buyback half its stock, significantly increasing the earnings power per share.  The future possibilities are just enormous.

For an alternative view on just how ridiculously cheap this company is, we might think about the business as my parents would, like a small business owner.  For $180 million, we would be paying $550,000 for each of the 325 company-owned units.  Paying $550,000 for an existing profitable store is a very low price, since it takes about that much capital upfront to open a new store from scratch.  And each of these stores can generate over $140,000 in cash flow per year yielding a 25% cash on cash return.  It’s certainly a much better business than a Team Electronics store.

Now that by itself would be a fantastic investment opportunity. But don’t forget that in addition we would also be getting some VERY valuable kickers for free: a perpetual 6% royalty on sales from each of Jamba’s 450+ franchised stores, a perpetual 3%-5% royalty on sales from licensing the consumer-packaged goods business, plus thousands of dollars per year from each of the hundreds of JambaGo units.  Yes, you read that correctly: at the current price investors are getting the most valuable pieces of the growing Jamba enterprise for essentially less than nothing!

Summary Recommendation

Buy JMBA up to $3.00 per share.  Our medium-term target is $8 to $10 per share over the next three to five years.  This is a long-term holding, and we expect the business to significantly compound in value over time.  However, this is a microcap stock that can be volatile.  We should always use Mr. Market’s irrational emotional swings to our advantage and be prepared to purchase even more shares at lower prices should we find ourselves fortunate enough to be presented with that opportunity.      

Sincerely,

Ryan O’Connor & Eugene Huang                                         

A couple of quick thoughts though before we delve into the numbers…

First things first, I wanted to quickly thank all of the amazing readers of this blog, especially those who’ve taken the time to write me with their thoughts and ideas, to comment and to generally share there thoughts on all things value investing over the years. To say it’s been not only wildly fun but the learning experience of a lifetime is an understatement. I’m quite certain in fact that I’ve learned more from the contacts and lifelong friends I’ve made over the course of the years writing this blog than I’ve ever given back and so for that, as with so many other things in life, I remain eternally grateful for the support and ongoing dialogue.

In fact, when I started this blog years back the idea that anyone would actually read it struck me as borderline preposterous, but life’s funny that way and what began as a humble project to feed my addiction to all things value investing while journaling my investing ideas – and if I was lucky, harnessing the “wisdom of crowds” in my research efforts here and there – has managed to not only surpass those expectations, but in truth ultimately far exceeded even my wildest imagination. So in short thank you, the reader, for making this endeavor such a rich experience and better yet, for making me a much better, more thoughtful investor over the years.

Secondly, I want to provide some context for the creation of the “new” AAOI blog portfolio of which you’ll see here today for the first time. As the natural follow up to the blogs real money Spoke fund, I think some explanation is in order but the goal is in one critical sense the same, meaning its purpose is to continue on in the tradition of tracking my investment performance in the public square over the life of the blog. In regards to the original AAOI Spoke Fund® and its fate, the short answer is that my transition to a new firm in early 2011 along with the dissolution of wealth-front as originally envisioned only a couple of months thereafter made the spoke fund’s continuation an unfortunate impossibility. This was a tough break no matter which way you slice it given the Spoke fund’s consistent history of substantial alpha generation, particularly in light of getting so close to that magical three year hurdle all of us emerging managers naturally look forward to surpassing.

Nonetheless, at the end of the day theres no sense in crying over spilt milk and of course, new opportunities called and so I moved on. That said, within a few months I decided another portfolio was needed if I was going to continue on with the blog as originally envisioned, both because on a certain level I think I owe it to readers in order for them to better gauge whether I’m worthy of their continued support, contributions, time, and energy – and because on a personal level, I wanted to continue on with a portfolio managed solely by my own hand.

Third, I wanted to address that with this new portfolio came a key change of heart as it relates to the wisdom of the original spoke fund’s policy of total transparency (read 24/7 real time access) to the fund’s holdings by the public at large as opposed to the fund’s investors specifically. My obligations to the LP’s I serve must always and everywhere come first.

Why that’s relevant specifically here is because it explains the new portfolio’s policy of only updating the results on an annual, and depending on the opportunity set at any given time, a potentially semi-annual basis thereafter.

So with all that said (if your still reading :)), lets get down to the mission at hand…

Since inception on 9/23/2011 until Feb 1, 2013 the AAOI portfolio has generated a total return of approximately ~55% vs. ~33% for the S&P 500, ~23% for the Russell 2k, and ~(-20%) for the S&P/TSX Venture index.

While my goal has always been absolute as opposed to relative performance, I was particularly pleased with the relative outperformance of the AAOI portfolio vs. the S&P/TSX-V index considering the relatively dramatic differential when over 50% of my holdings were listed on the venture exchange, at least over most of the time period in question.

Regardless, I was more than pleased with the portfolio’s results from an absolute standpoint. While difficult to pin down exactly given the Sandstorm Gold and Star Buffet errors, (after adjustments) it appears the annualized return has clocked in at roughly 40% give or take a percent since inception.

If I can manage to somehow continue at this rate going forward I would obviously be ecstatic, but unfortunately something closer to half the current run rate is likely to be closer to what is achievable on a sustainable basis. That said, I should add that even with all the uncertainty in what I continue to believe is a risk-fraught global economic environment I can’t remember ever being so bullish on the prospects of my current holdings, specifically as it relates to my highest conviction pics. Turning back towards the question of future performance though, if I can manage to generate returns approximating even half the present run-rate over the long-run, rest assured your editor will be more than pleased.

Thanks again for everything and here’s too the next five years of low-risk, high-return investing at Above Average Odds Investing being even better than the last – and rest assured the search for opportunity and hence, for those exceedingly rare, one of a kind “epic investments for posterity” rolls on.

Footnotes:

(1) The SSL error is a function of Investopedia’s failure to account for the 5:1 reverse stock split. Regardless, adjusting for the change, the quantity of shares owned should approximate 1700, so the value of my SSL position in the Canadian account is ~$21k, not $93k. Therefore, the Canadian account value should equate to ~148k (220k-72k), not 220k.

(2) Also, in case your wondering why I’m just now publishing these returns given that we are roughly four months past the one-year mark, the answer is twofold. First, originally I had held off in hopes that Investopedia could fix the Sandstorm Gold related error with the goal being to allow me to unveil the portfolio in a cleaner fashion. This seemed entirely reasonable at the time given that all the other journal entries related to the portfolio’s various corporate events had been accounted for, or if temporarily in error, at least promptly fixed by Investopedia’s admin. After about three weeks of trying to get the issue resolved that hope unfortunately turned out to be in vein, and for some reason still inexplicable to me, not possible. Anyhow, given this seemingly non-fixable error I’ve just decided to include an explanation on how I adjust for this above. The other reason was because shortly thereafter I found a handful of ideas (really one in particular) that imo required secrecy and hence necessitated a further delay. For what its worth, with a defined process in place going forward I don’t expect any future delays to be an issue.

(3) The Star Buffet position has recently emerged from bankruptcy and hence has lost the Q in its ticker as it begins trading again as a post bankrupt entity. Unlike with SSL, this change should be be accounted for shortly although, also unlike with SSL, the net effect will be pretty much immaterial in terms of its effect on the portfolio’s performance. I figured I should note it anyway.

(4) As always I also hope readers will point out any errors or discrepancy’s if they come across any, as I’m not entirely certain the Sandstorm Gold issue hasn’t effected the total and annual returns at the margin in a manner that I haven’t considered, but then again I don’t expect it to be material either. To paraphrase Buffett, the goal here was to be approximately correct rather than precisely wrong.