Value Library
The following is an excerpt from the ABC Perspective -
October 2010 - Pg. 4-5
ABC Fund Value Favourites
Cogeco Cable Incorporated
Cogeco’s publicly-traded cable subsidiary, Cogeco Cable Incorporated (TSX: CCA), offers analogue and digital cable, high speed internet and telephony services to residential and commercial customers. It is the second largest cable telecommunications company in Ontario, Quebec and Portugal with approximately 3.1 million revenue-generating units from almost 2.5 million homes that are passed by its network.
Regular readers of the ABC Perspective should remember our comments on Cogeco Inc. (TSX: CGO) and Cogeco Cable Inc. (TSX: CCA) from last year. Recall that in November 2009, we sold our stock opportunistically at a significant premium to the market. However, we have now rebuilt a position in Cogeco Cable Inc. (TSX: CCA) at lower price levels.
Our original thesis for investing in Cogeco Cable remains intact. During difficult economic times, people generally look for small comforts and little “pick-me-ups” as we cut back on luxuries. Cable TV, internet access and services such as video-on-demand are now substitutes for an expensive night out. In this environment, we think that cable companies offer a nice mix of defensiveness and growth and Cogeco Cable is simply a cheap stock in the right sector.
Today, Cogeco Cable trades at a discount to Rogers Communications (EV/EBITDA of 5.3x compared to 7.0x trailing and 5.5x compared to 7.3x forward) despite a higher consensus EBITDA growth rate (5.7% compared to 3.6% in 2011). In fact, the spread between the two companies is actually larger than it was at the time of our original purchase. Importantly, financial results are improving and management recently updated preliminary guidance for fiscal 2011, forecasting $530 million in operating income and $55 million of free cash flow based on the net addition of 250,000 RGUs (revenue-generating units). Narrowing the valuation discount relative to Rogers remains a two pronged-approach for management.
First, there is plenty of room for Cogeco Cable to improve its penetration rates relative to its well-known peer. This measure is used to compare the number of subscribers relative to homes passed by the Company’s installed network. Currently, Cogeco Cable lags Rogers Communications in several key categories: basic video at 55% compared to 63%, digital video at 34% compared to 47% and internet at 35% compared to 45%, respectively. Growth will come over time, as marketing and service bundling gain traction.
Second, the resolution of Cogeco Cable’s difficulties with its Portuguese cable operations, known as Cabovisao, could be a major catalyst for trading-multiple expansion. Cogeco Cable originally bought Cabovisao in 2006 for approximately EUR465.7 million or roughly $660 million. Although lower cable and internet penetration rates in Portugal originally presented a growth opportunity, competition from the two largest incumbents has been intense. However, Cabovisao has finally shown some signs of stabilization. Over the course of the first nine months of fiscal 2010, Portugal added 75,801 net RGUs and compared to losing 13,021 net RGUs in the comparable period in 2009. As management stated, “While Europe’s economic difficulties persist, the competitive situation in Portugal appears to be settling down”. We believe that either fixing these operations, which have already been written-off by $399.6 million or selling them would provide a lift to the stock.
One other potential catalyst exists, but whether this ultimate scenario actually plays out is unknown. Rogers Communications owns approximately 33.6% of the subordinate voting shares of Cogeco Inc. and 29.8% of the subordinate voting shares of Cogeco Cable Inc. In fact, last November Rogers purchased 3,200,000 million subordinate voting shares of CCA and 1,623,500 subordinate voting shares of CGO to increase its ownership. Perhaps one day Roger’s management might negotiate a deal with the Audet family and buy the balance of Cogeco Cable that they don’t already own.
In summary, we have repurchased shares of Cogeco Cable Inc. because of its mix of defensiveness and growth. The Company pays an annualized dividend of $0.56 per share, which yields approximately 1.6% at current price levels. We think that upside to the story comes from narrowing the penetration rates relative to Rogers and either turning around or selling Cabovisao. In any event, we believe that Cogeco Cable is relatively undervalued and that, over time, investors will be rewarded.
Energold Drilling Corporation
Drilling Corporation, based in Vancouver, is a global contract driller for the mining industry. The Company operates 94 specialized, highly mobile rigs in over 22 countries worldwide, focusing on “frontier drilling” in remote or harsh locations. Driven by demand, Energold has grown its rig fleet by 30% per year, on average, and expects to exit 2010 with 100 rigs. Over 70% of the Company’s operations are linked to gold exploration and production with clientele ranging from well known majors to early stage juniors.
Energold Drilling Corporation (TSXV: EGD) is essentially a contract driller targeting base and precious metals. As opposed to conventional underground or open pit mining, the Company is active during the early stages of exploration and development of new deposits, which spans from the first green-field drill program all the way to resource definition drilling. Not surprisingly, when times are good, the margins on this type of work can be exceptional.
When we purchased our initial stake in Energold, we were intrigued with several key aspects of the story. Frontier drilling had collapsed during the credit crisis, since most companies were simply trying to conserve cash and remain afloat. Energold’s stock was depressed, trading right around book value of $1.88, despite having almost $0.65 per share of net cash on its balance sheet. However, we took comfort in the fact that Fred Davidson, the Company’s President and CEO, and management owned approximately 10% of the common shares outstanding. Further, we believed that Energold’s 13.6% stake (6.65 million shares) in a profitable silver producer, IMPACT Silver (TSXV: IPT), was a hidden asset that the market had overlooked. Finally, we liked that the Company built its rigs in-house, ensuring familiarity with the equipment and better relative performance including quicker turnaround times between rig setups, greater depth capabilities and bigger core diameters.
Although we are not “gold-bugs”, we are aware of the factors that have been driving the appreciation of the precious metal. Paradoxically, the credit crisis froze gold exploration as the debt and equity markets closed to more speculative investments. Starved for capital, frontier drilling activity slowed to a crawl. In the first quarter of 2009, Energold’s meters drilled fell to 20,490 down 64% on a year over year basis. However, activity has been picking up steadily, along with the rise in the price of gold, and in the second quarter of 2010 Energold drilled a record 86,000 meters up 131% from a year ago and 58% sequentially.
Profitability, measured by both average revenue per meter and gross margin, has lagged the recovery in meters drilled. In the most recent quarter, average revenue was $150 per meter compared to a peak of $194 per meter in the third quarter of 2008. Although the gross margin has rebounded somewhat from a low of 15.9% to 23.8% in the second quarter of 2010, it is still well below the peak gross margin of approximately 45%. Basically, the majors have begun to deploy capital but the intermediates and juniors are just now closing financings to fund planned drill programs. Spending by the smaller companies in the sector is the gravy on this story because they are more willing to spend aggressively on exploration and less likely to be able to negotiate pricing. Once the exploration campaigns resume in earnest, we expect Energold’s profitability to increase dramatically.
In summary, we believe that Energold is an intriguing small-cap story with tremendous upside potential. The Company is growing its rig fleet, has a pristine balance sheet and owns a hidden asset in IMPACT Silver. As the gold price continues to move higher, mining companies are faced with drilling in more remote locations because the “low-hanging fruit has been picked”; very few significant discoveries have been found over the past five years. To replace depleting reserves and resources, the senior producers have two options: increase exploration budgets or look for acquisitions. At the other end of the spectrum, the intermediate and junior gold companies will drill aggressively in order to prove-up their properties and maximize value. In either case, Energold is poised to reap the financial rewards of the rising exploration activity.
Irwin A. Michael, CFA
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