Value Library

The following is an excerpt from the ABC Perspective - July 2011 - Pg. 4-5

ABC Fund Value Favourites

Bennett Environmental Inc.

Bennett Environmental (BEV:TSX) is an environmental services company that specializes in the high temperature treatment of contaminated soils. The company owns and operates a 100,000 tonne soil remediation facility located in Saint Ambroise, Québec, and markets its services in Canada and the United States. BEV’s technology is based on a thermal oxidation process that utilizes a rotary kiln, giving it the ability to treat most types of contaminated soils in a variety of chemical forms.

The market for soil remediation is largely dependent on federal and provincial government funding. Customer contracts are normally project-based, which can range from a month to several years in duration.  With this in mind, the soil treatment business is inherently lumpy, and cycles can span several years. At times when soil inventory is low, Bennett may store the material until it has sufficient volumes to take advantage of economies of scale. Typically, BEV needs approximately 20,000 tonnes of soil before it will operate the St. Ambroise plant. While the company had approximately 16,000 tonnes of soil in inventory at February 2011, we believe it could be targeting additional contracts that would allow it to profitably operate the facility.
From a financial perspective, Bennett’s operations are capable of generating significant cash flow. Indeed, under more favourable market conditions, BEV has previously generated a gross margin in excess of 50%, and EPS of greater than $1.00.  With only minimal capital required to sustain operations, free cash flow can be substantial when Bennett has secured sufficient quantities of soil.
The soil treatment business is dependent on the receipt of government permits for the remediation and importation of contaminated soil, which can be a costly and time consuming process. For example, the approval process can require an environmental assessment study, which can cost several million dollars to complete. Furthermore, importation of contaminated soil into Canada requires both federal and provincial consent, including approval from Environment Canada. As such, while Bennett does face some competition from landfills and alternative treatment technologies, the extensive permitting process and import restrictions in many instances can act as a significant barrier to entry for new competitors.

Bennett’s history has been one of prosperity, followed by turmoil.  The company’s shares peaked in early 2004 at $28.13, as the market recognized the significant free cash flow capability of its business. The fact was that BEV’s operations were at the time highly levered toward funding from the United States Superfund program, a federal act designed to clean up contaminated sites in the US. However, once Superfund money was substantially exhausted by the end of 2003, BEV’s business weakened. Additionally, Bennett and its previous management became the subject of much scrutiny when the company pleaded guilty to participating in a conspiracy to defraud the US Environmental Protection Agency over the period 2002-2004; as a result, BEV received a $1 mm criminal fine. As the market became aware of the allegations against BEV and its previous management, its shares were pummeled to all-time lows, eventually bottoming in 2008 at just $0.09/share.

Despite its tumultuous history, much has changed at Bennett since the controversy of nearly a decade ago. Founder and Chairman John Bennett resigned in 2004, and the company has been recapitalized and has publicly stated that it is seeking growth initiatives. Most recently, BEV completed a $25 mm financing in May 2010 at a price of $3.05/share, and had over $60 mm in cash – or $1.55/share at June 29th, 2011, and no debt.

While the 2010 financing was intended to support a near-term acquisition opportunity, to-date, no acquisition has yet been completed. With this in mind, the company’s largest shareholder – Second City Capital Partners (23% owner), requested that shareholders approve a new slate of Directors that would examine a range of strategic opportunities.  With the endorsement of our ABC Funds, which currently hold 7 million shares or 18.17% of the company, a new Board was approved by shareholders at Bennett’s AGM held on June 29th, 2011. In addition, the new Board subsequently installed Mr. Lawrence Haber as Director, interim CEO, and future Chairman of the Board once a permanent CEO has been announced.

Equitable Group Inc.

Equitable Group Inc. (ETC:TSX) is a niche mortgage lender that specializes in first charge mortgage financing. The company provides services to single family, small and large commercial borrowers, and their mortgage advisors. In its single family business, ETC can serve as alternative lender to borrowers who are unable to satisfy the strict underwriting criteria of conventional bank mortgage lenders.

For 2011, Equitable expects that the Canadian real estate market and a general healthy employment outlook will provide a favourable operating environment for the company. With this in mind, after achieving exceptional growth rates for its origination and lending business in 2010, ETC expects more moderate growth rates this year, particularly with regard to single family residential mortgage lending. However, recent expansion efforts in Canada, including the commencement of lending activities in Saskatchewan, are expected to result in rising origination volumes for 2011 and position the company to achieve significant earnings growth in future periods.

On May 17th, Equitable reported its Q1 2011 financial results. In our view, ETC’s first quarter results were exceptionally strong, with net interest income – the main driver of profitability – increasing by 8.9% year-over-year, diluted EPS increasing to $0.99 versus $0.88 in Q1 2010, and an adjusted ROE of 17.8%. Q1 2011 originations totaled $667 million, up 35% year-over-year, and total assets reached a record $9.2 billion. While the change to International Financial Reporting Standards (IFRS), resulted in a downward adjustment to shareholders’ equity of $44 mm (approximately $3.00/share), this will be recovered in future periods reported under IFRS.

In connection with its Q1 2011 results, ETC raised its quarterly dividend to $0.11 (from $0.10), such that the stock now provides a dividend yield of approximately 1.4%. While the dividend increase appears relatively modest, it did represent ETC’s first dividend increase since 2006. Given strong origination growth and the potential for higher net interest income, we believe future dividend increases are possible.  We do note that ETC remains well capitalized, with a Tier 1 capital ratio of 14.7% and a Total capital ratio of 17.4% at Q1 2011. Management has indicated that this level of capital should be sufficient to support its growth initiatives.

ABC Funds initiated a position in Equitable Group in July 2008, by way of a bought deal offering that was priced at $21.50 per share. While our investment in Equitable reflected a value-oriented approach, we also respected the company’s growth prospects. For example, as ETC shifted its product mix toward residential mortgages away from commercial mortgages, we believed it would unlock the substantial earnings power and ROE capability inherent in ETC’s business. It is important to note that residential, single-family mortgages are more profitable, resulting in a higher net interest margin, while at the same time requiring lower regulatory capital.

As demonstrated by its recent strong financial performance, results of ETC’s growth strategy are bearing fruit. As noted earlier, in Q1 2011, Equitable’s net interest income increased 8.9% year-over-year, while its non-securitized mortgage principal increased by 30% to $3.7 billion. This growth was supported by a significant increase in single family lending services, which increased by 70% year-over-year. Notably, ETC’s single family lending business now accounts for 45% of the loan portfolio compared to 35% last year.

Although our investment in Equitable has appreciated by approximately 40% (excluding dividends) since we acquired our position in July 2008, the fact remains that ETC continues to trade at a discount valuation. Despite its impressive financial performance, sizeable mortgage portfolio, and ability to generate an ROE in the mid to high teens, the stock continues to trade at a surprisingly low multiple to earnings and book value. To put this into context, at current levels, ETC is trading at just 1.3x book value, and a P/E ratio 7.5x 2011 consensus analysts’ estimates. By comparison, ETC’s closest peer – Home Capital Group – trades at a 9.5x P/E multiple based on 2011 consensus estimates and over 2.5x book value.

Irwin A. Michael, CFA