Update No. 236 – 09/10/15

We’ve had a busy couple of weeks, with quite a bit of buying taking place. I mentioned a couple of small positions in the last quarterly (.pdf). I said I would discuss them in the blog after they had played out and one more or less has now, so I will try to explain the thinking in it, and why it was such a tiny position and the type of thinking we use at EGP to try and generate risk adjusted returns for our shareholders.

Mobilarm (MBO) is a microcap company that sell Marine Rescue Technologies. These are mostly electronics enabled devices like locator beacons, life-jackets and dan-buoys whose primary job is to assist with protecting lives in the marine environment. Think locating a sailor after a ‘man-overboard’ incident or the like. In any case, the equipment is very well regarded in the industry and certainly mission critical in terms of the OHS/WHS focus businesses operate with in modern times.

I have probably followed the company closely for the last 12 months or so. Two investors whose opinions and analysis I rate highly mentioned the company to me separately as one that was very interesting and worth keeping an eye on. MBO is currently about NPAT break-even and considerably cash-flow negative as they switch from a ‘sale of equipment’ model to an ‘equipment rental model’. I will rarely buy a business that is not yet making money, unless the scale of future profitability looks so obvious to me as to make purchase at current valuations irresistible. Over time, as the rental model matures, the business would seem to be capable of generating good solid growth, with a nice stable underlying/recurrent revenue stream. It is an extremely small company, untouchable to major fund managers, just the area a little firm like ours should be exploiting.

To my view, given the risks in the industry, the evolution in the business model taking place and the uncertainty inherent in such things, the slightly more than $14m (a little over 350m shares at a little over 4 cents per share (CPS) on average) valuation the market had ascribed the business at over the preceding 12 months looked about right to me. Such a valuation would be obviously low if things go right, but on the balance of probabilities, such a valuation seemed roughly right until the runs started to make their way onto the board. So I was not a buyer at current prices.

What I was, however, willing to do was to observe the company closely over time and if I saw signs the new business model was maturing, and the market was failing to recognise and value this correctly, step in and begin buying.

At the end of July, I was tempted into action early, when the company proposed the type of equity raising you are unlikely to see more than a couple of times a year. The proposal was for a 1 for 1 non-renounceable rights issue at a price of 0.7 CPS. The 0.7 CPS was a roughly 85% discount to the average share price over the preceding 12 months. This is a jaw-droppingly large discount. Such discounts often indicate that a company is in massive trouble. In this case, I was quite sure this was not the case. The CEO already owned more than 14% of the stock and had committed to underwrite 61.85% of the offer. Effectively, he was willing to stump up for more than three-quarters of the offer. CEO’s can be prone to blindness when it comes to their businesses, but will rarely throw more than $1.5m into a black hole (such was the value of the underwriting).

In simple terms, if a little over 4 CPS was about fair value prior to the proposed rights issue, the post-rights valuation would be comfortably more than 2 CPS. The opportunity to buy something at less than one-third of the assessed valuation is not one that should be overlooked…

I came to the conclusion that there was an opportunism in what was happening. The CEO seemed to be daring his existing shareholder base not to take up the offer. If they didn’t subscribe for all of the rights issue, he would be buying a large portion of the company out from underneath them at a bargain price.

On 4 August, I purchase 17,000 shares at 3 CPS for the fund. $510 seemed a small price to pay to give us the opportunity to participate in such a deeply discounted offering. My intention was to massively oversubscribe, in the hope I picked up a decent position in the shortfall offer.

The company then withdrew the rights offer on 17 August.

They then changed the terms of the prospectus to a 2 for 5 offering. The company, it seems had considered what had occurred to me (and presumably some other alert market participants), and closed the oversubscription door in our face. Section 4.8 of the revised prospectus set out that the underwriters would be entitled to the first 85 million shares of the roughly 140 million now to be issued. This ensured that the CEO would get his full block of any unsubscribed rights before we got our share.

The upshot of the re-structured offer was that we got the 6,800 shares we were entitled to under the 2 for 5 offer and 173 shares in our ‘over-subscription’ (at a value of $1.21).

I was being unashamedly opportunistic in my efforts here – that is my job as the steward of your capital. We applied for a large enough oversubscription that we would have held 10 million MBO shares had we received all we applied for. Instead we now own 23,973.

The last trade for MBO was at 1.4 CPS. My sense (per paragraph 7 above) is that that almost certainly undervalues the company, though not nearly as badly as 0.7 cents did…

Were I more certain of the intentions of management in acting solely in the best interests of their shareholders, I would probably build this from our smallest position as it is currently, into a larger position.

However, the more I think about the way the equity raising described above was undertaken, I don’t know that I’m willing to entrust a management capable of acting with such disregard for their shareholders with additional capital. Particularly galling was the revised rights issue. When they realised that some market participants (such as EGP) had tried to get in on the same oversubscription caper the CEO was himself undertaking, they moved the goalposts. The initial equity raising was poorly priced and made it appear that management didn’t know what they were doing. The revised equity offering made it obvious they did know what they were doing. Unfortunately, that is probably worse…

That being the case, I will almost certainly eliminate the position. The position cost us about 2.33 CPS ($510 + $48.81/23,973), every 0.1 CPS we sell short of that will cost the fund about $24. Had we been successful in our full oversubscription, our 10,000,000 share-holding would have cost us 0.704 CPS, or nearly 70% less per share. At current market valuation (if it holds, and a rights issue will almost always tend to hang around the issue price for a while), had we received our full subscription, we would have materialised a nearly $70,000 profit from next to nothing. For many a large fund, this would be immaterial, but we are a very small fund, and it would have been most welcome!

Think the efforts described above through and you’ll see how much we could have benefitted had the cards fallen our way – given that we’re still managing less than $5 million, at that size, every $50,000 is more than 1% added to the outperformance line. We spend a lot of time and effort ferreting out such situations where the risk/reward metrics are so heavily skewed in our favour. It just appears this one didn’t quite work out. We redouble our efforts – Tony Hansen 09/10/2015

EGP Fund No. 1 Pty Ltd. Up by 2.64%, leading the benchmark by 2.87% since July 1^st 2015. Since inception, EGP Fund No. 1 Pty Ltd is Up by 90.58%, leading the benchmark by 54.49% all-time (April 1^st 2011).

^{*1 after a 31 May 2013 dividend of 2.333 cents per share (cps) plus 1.000 cps Franking Credit, a 31 May 2014 Dividend of 7.000 cps plus 3.000 cps Franking Credit and a 31 May 2015 Dividend of 8.6667 cps plus 3.7143 cps Franking Credit}

^{*2 calculated based on dividends reinvested}