Value Investigator - Value Library

ATS Automation Tooling Systems Incorporated (TSX: ATA) designs, builds and installs automated manufacturing systems for the healthcare, electronics, energy, automotive and consumer products industries. The Company operates through two divisions, Automation Systems Group (ASG) and Photowatt Technologies. ASG manufactures the various automation systems and Photowatt manufactures solar wafers, cells and modules. ATS employs approximately 2,600 people at 17 manufacturing facilities in Canada, the United States, Europe, Southeast Asia and China.

At the peak of the high technology boom in 2000, ATS traded above $40 per share. Although the Company was profitable, the valuation was excessive. When the bubble burst, profit growth failed to meet expectations. Over the course of the next nine years, the shares declined to a low of $2.74, a drop of almost 95%. However, we believe that recent developments have been positive and the underlying results have shown a material improvement.

Significant, beneficial changes began on September 13, 2007 when shareholders elected a new Board of Directors as proposed by Goodwood and Mason Capital Management, two activist shareholders. A new management team was brought in and Anthony Caputo was appointed as CEO. Mr. Caputo previously held positions at L-3 Communications and Spar Aerospace, which was bought by L-3 for $230 million. Given his track record, we have great faith in his ability to create shareholder value.

Mr. Caputo and his team quickly identified the Company’s key strengths that could be leveraged to exploit opportunities in their marketplace, including a dedicated workforce, significant technical depth and breadth across multiple industries and long-term customer relationships with Fortune 500 companies. The initial action plan to immediately fix what wasn’t working included:

improving management’s leadership, business processes and performance management
fixing Automation Systems Group’s approach to market and core operations
positioning Photowatt as a standalone entity
strengthening the balance sheet through credit agreements, cash management and monetization of redundant or non-core assets

and
selling the Precision Components Group

Progress thus far includes the monetization of approximately $65 million of non-core assets, including the sale of the Company’s Canadian solar operations, the sale of a redundant building and the sale of the Precision Components Group. Management recently signed an $85 million credit agreement and completed a bought deal financing for $50 million at $5.00 per share. At the end of the Company’s most recent quarter (Q1 of fiscal 2010) the net cash position totaled $86.6 million, or approximately $1.00 per share. Investors should be pleased with these developments but we need to assess management’s progress with the core operating segments, ASG and Photowatt.

Thankfully, the Automation Systems Group segment has shown a real improvement in profitability, despite the incredibly difficult economic environment. In the most recent quarter, revenue declined 19% year over year. However, ASG’s operating margin improved impressively from 8.6% to 14.5% and EBITDA increased 36% from $12.3 million to $16.7 million. On another positive note, the backlog for healthcare-related orders actually improved on a year over year basis. As the recovery broadens to other sectors, we think that ASG’s profitability could surprise the market.

The Photowatt Technologies segment, unfortunately, is facing a more difficult environment. In the most recent quarter, Photowatt reported an operating loss of $7.5 million and negative EBITDA of $3.4 million. However, the quarter included an unusual warranty charge of $4.7 million related to a “specific customer contract which contained an incremental performance clause”. The division was also temporarily closed for a three week period, which further negatively impacted the results. Government subsidies, such as feed-in tariffs, should eventually lead to rebounding sales and profits. Hopefully, management will be able to surface value in this segment as the performance improves from what should be the trough quarter.

We purchased our position in ATS between 0.6 and 0.7 times the current book value of $6.40 per share and approximately 3.5 times trailing twelve month EBITDA. Today, the shares are trading at 0.9 times book value and 5.0 times EBITDA, which is still inexpensive. At five times trailing twelve month EBITDA, we believe the ASG segment could be worth $3.60 per share. At 1.0 times trailing twelve month sales, the average multiple on players in the solar power industry, Photowatt could be worth an incremental $2.75 per share. Adding the cash position implies an intrinsic value today of $7.35 per share. Possible catalysts for an even higher share price would include an accretive acquisition, perhaps in the healthcare industry, or the divestiture of Photowatt Technologies at the right price.

Daylight Resources Trust (TSX: DAY.UN) is a mid-cap conventional royalty trust that is anticipated to produce 38,000 boe/d of natural gas and oil for the balance of 2009. The Trust was formed as a result of the merger between Daylight Energy Trust and Sequoia Oil and Gas Trust on September 21, 2006. The recent acquisition of Highpine Oil and Gas Limited created a more balanced production mix by increasing the oil and liquids weighting from 28% to 42%. Daylight pays a distribution of $0.08 per month, or $0.96 per year, which yields approximately 11% at current price levels.

The traditional link between natural gas and oil prices seems to have broken down. Historically, the ratio of oil price to natural gas price moved in a broad range of six to ten times. Today, the ratio is roughly twenty times and it probably peaked in 2009 with oil thirty times the price of natural gas. This relationship decoupled for two key reasons. First, there has been a tremendous amount of new supply of natural gas due to technological advances, such as multi-stage fracturing. Second, oil is a politically-sensitive, global commodity while natural gas is a localized, North American commodity. To put it simply, North American economies are still weaker than those in Asia. However, we believe that natural gas prices will recover from seasonal lows and strengthen as we get closer to winter.

From our perspective and despite today’s weak natural gas price, Daylight’s acquisition of Highpine Oil and Gas Limited gave us the confidence to build a meaningful position in the Trust. The $530 million acquisition was accretive to cash flow, rebalanced the production mix from 28% to 42% oil and liquids, improved the debt to cash flow ratio to 0.9 times and created a much more substantial entity with an enterprise value of approximately $1.8 billion.

Operationally, Daylight has conventional production and extensive land holdings in Alberta, including assets in the West Central, Pembina and Central regions of the province. However, the Trust’s core Deep Basin properties could hold significant resource potential. Importantly, cash flow from Highpine’s Pembina light oil and Daylight’s conventional natural gas, with a significant amount hedged at an average price of $8.00 per mcf AECO, will be used to develop this resource play.

A resource play has to have a large, repeatable drilling inventory, with low geological risk and very attractive economics. Development becomes almost “cookie-cutter” over several years, with hundreds of wells drilled if sufficient capital is available. Therefore, the importance of Daylight’s cash flow from oil production and hedged natural gas production cannot be overstated. Essentially, the Trust’s Deep Basin, Elmworth assets are prospective for the Cadomin, Nikanassin and Montney formations. The area contains 130 net sections of land with the potential for 4 wells per section, or 520 wells. Even with capital costs of $7 million per well, and assuming a $5.00 per mcf AECO gas price, each well has a net present value of $5.1 million according to Daylight’s internal estimates. If we consider the number of possible drilling locations, the appropriately risked upside is quite exciting to say the least.

Pro forma the Highpine acquisition, Daylight is still in excellent financial shape. With combined bank credit facilities of $550 million and $205 million drawn at the end of the second quarter of 2009, the Trust has ample flexibility to pay its distribution or even consider a smaller, tuck-in type acquisition. An acquisition larger than $300 million would require converting back to a corporate structure, which we believe is likely to occur anyway some time in early 2010. Finally, under current assumptions, the Trust’s payout ratio should remain around the 50% to 55% range, which is quite conservative.

Using the Trust’s year end financial and reserve data, we believe that Daylight is still trading below its net asset value of $9.78 per unit. Although adding Highpine increased proven and probable reserves from 76.9 million boe to 108.1 million boe, the net asset value per share is unlikely to have changed materially. However, accelerating the development of the Trust’s resource plays has the potential to significantly increase the NAV per share going forward.

We believe that Daylight’s management, led by Anthony Lambert and Steve Nielson, are building a significant medium-sized Company. Through organic growth and perhaps additional acquisitions, we believe that Daylight could become a much larger entity. Conversion back to a corporation is inevitable and even if the distribution is reduced we believe that the market would positively focus on the burgeoning growth opportunities. In the meantime, we are getting paid to wait for the natural gas price to recover and the development of Daylight’s key assets to play out.