Warning: Canlan (TSX:ICE) trades very infrequently. The company has a market capitalization of $50 million; only 10% of which is considered free float (ie. actively trading). If you are looking for a hot stock pick, do not bother reading further. But if you are interested in process, which I hope you are, this should be a useful post.
A Quick Look at Canlan Ice Sports (TSX: ICE)
Every once in a while, you come across a stock that you immediately like. You read the business description and instantly want to go to your brokerage account to buy. For me, Canlan (TSX: Ice) was one of those stocks. Canlan acquires, operates and develops ice hockey rinks that are mainly in Canada. It’s an easy to understand business which appeals to me. Whenever you come across a company like this, it is important to recognize you have an emotional bias. You can combat emotional biases by sticking to a rational process.
Let’s look at Canlan through the same process that I initially outlined in my post on Mediagrif (TSX: MDF). There are four attributes I look for in an initial view 1) Capable management teams and board, 2) Strong balance sheets, 3) Profitable growth, and 4) An attractive valuation.
Step 1: Is the Management Team capable?
The first thing I look at in determining if a management team is capable is whether management’s interests are aligned with shareholders. An important source of information is the management circular posted on Sedar. In the management circular, you can figure out how much management pays themselves and if there are any significant shareholders.
Pg 4 of 21 of the Canlan Circular has the excerpted paragraph below. We can see that 76% of shares are owned by Bartrac Investments and 16% by a trust.
Pg 3 of 21 of the Canlan circular has the names and principal occupations of the Board of Directors. From this, we can take away that Canlan’s major shareholder has representation on the board. This is a good sign when making the determination whether Canlan’s management is aligned with shareholders.
Pg 7 of 21 of the Canlan circular has the summary compensation company for management. There are a couple things to look for here. The first is excessive use of options and share-based awards. The second is whether total compensation is reasonable. I generally get worried when management of a small company like Canlan (market capitalization of ~$50 million) pays itself more than $500,000 per annum.
After looking at compensation, the next thing to look at is management tenure. Joey St-Aubin became CEO of Canlan in 2009. Prior to being CEO, he spent 11 years at Canlan starting as the general manager of a facility. In total, St-Aubin has been at Canlan for 20 years. This is a good sign. If you see that a new CEO has been brought in from outside the company (ie. an external hire), it can signal that something has gone wrong and the board has been forced to look outside the company for a fresh view.
Summary: In summary, management of Canlan looks capable on an initial view. There is a large shareholder with representation on the board. The executive team does not pay themselves excessively and the CEO is tenured. The next step would be to look at the board/management’s track record in terms of capital allocation, strategy, and execution. This requires a much deeper dive and is more suitable for a second phase of analysis.
Step 2: Is the Balance Sheet Strong?
To assess, the balance sheet, we look at the most recent available quarterly financial statements on Sedar. We can see debt totals $57 million (including financing leases). Cash is $14 million, so debt net of cash is $43 million. Total net debt is not much good to us in a vacuum. We must look at net debt in the context of Canlan’s earning power and the assets used to generate earnings.
The industry consensus is to look at EBITDA relative to net debt as a determinant of debt capacity. We can pull EBITDA right off of Canlan’s income statement (see below). Note that many companies do not have depreciation in the income statement, meaning you need both the income statement (where you find EBIT) and cash flow statement (where you find depreciation and amortization) to calculate EBITDA. Canlan is in the middle of its year so it is usually best practice to look at the last twelve months which we can do by taking 2016 EBITDA and adding EBITDA from the first 9 months of 2017 and subtracting EBITDA from the first 9 mths of 2016. So the calculation is: $12.2M +$7.3M – $6.9M = $12.6M.
A simple calculation gets us to Canlan having 3.4x net debt to EBITDA (net debt of $43M divide by LTM EBITDA of $12.6M). 3.4x net debt to EBITDA is a high ratio. As a general rule, companies with above 3x to 4x net debt to EBITDA are not considered investment grade by the major rating agencies (S&P and Moody’s).
There are two mitigating factors for Canlan: 1) the company is noncyclical; Canadians play hockey in good and bad economic times, and 2) Canlan’s debt has hard assets attached to it (ie. real estate). Banks would generally view this favorably relative to a company who only has intangible assets built up from acquisitions over the years.
Given the mitigating factors, I am willing to say Canlan’s balance sheet while far from ideal is still okay from a potential equity investor standpoint.
Step 3: Can the company grow profitably?
It is important to note here that I mention profitable growth rather than just growth. It is not enough to just grow – with an unlimited amount of money or funding, any company can grow. The key to the growth is that it is profitable.
Generally, for growth to be profitable, the company under analysis must have a competitive advantage. Canlan appears to have scale and associated network effects in that it is the largest operator of hockey leagues. Scale helps leagues in many way. One is finer segmentation of player skills. The more people you have, the easier it is to create leagues of people with similar skill levels. Anyone who has ever participated in recreational sports knows that it is a bummer to play with people way worse or way better than you. Another advantage is scheduling. With more people, you can offer several leagues at different time slots to appeal more people’s scheduling.
It is generally easier to assess profitability before growth. You can assess profitability by looking at a snapshot. Growth generally requires looking at the company over a long period team; meaning statements from several different years.
In terms of profitability, I like to use a shortcut of looking at EBIT relative to invested capital. Company’s tax rates can bounce around and this takes that volatility out of the picture. It also excludes ‘below the operating line’ items that are one time in nature.
We have already calculated Canlan’s EBITDA. The next row down is D&A so we can calculate EBIT by subtracting D&A from EBITDA. Or in numbers: ($12.2M – $7.0M) + ($7.3M – $5.2M) – ($6.9M – $5.2M) = $5.6 million.
In terms of invested capital, we have already calculated net debt of $43M, so all we have to do is add shareholders’ equity of $43M (looks like a type-o, but it’s not – both net debt and s/h equity are both $43M). Total invested capital is $86M ($43M + $43M). It is important to note in a more detailed analysis we may do things like add back impairments in prior years to this amount (Canlan had a $4M impairment in 2015). But this is not necessary at the current stage of analysis.
So based on these numbers, we get to pre-tax return on capital of 6.5% ($5.6M / $86M). This is weak in my opinion.
One possibility I thought of is maybe Canlan is depreciating its buildings too quickly and they actually have a longer useful life. This would mean D&A is too high and the result would be that the EBIT we are looking at should actually be higher. Pg 46 of 62 Canlan’s 2016 annual report has the table below showing that buildings are depreciated over 40 years. I’d also note that Canlan’s gross amount of “Buildings” is $117M and it is recognizing depreciation on buildings of $3.8M which implies a life of 31 years ($117M divide by $3.8M). Based on this, I do not think Canlan is depreciating the buildings too quickly; 30 to 40 years seems like a reasonable estimate of a useful life.
The 6.5% pre-tax return on capital that Canlan earns is indicative of a lack of competitive advantage. There must be something else going on outside of the scale advantages I listed earlier. My view is that it is hard to earn good returns on capital when your competition is publicly subsidized non-profit organizations. Many hockey and other leagues are structured as non-profits. They also get access to government-owned facilities like community centers at a good price. When you own your rinks, it is difficult to make good returns up against this sort of competition.
Step 4: Is the valuation attractive?
There are three metrics that I like to look like to get a quick sense of valuation: P/B, EV/EBITDA, P/E ratio.
For price to book, we already know shareholders’ equity is $43 million. We also need share price and shares outstanding. We can find number of shares outstanding of 13.3 million in note 7 of Canlan’s Q3/17 results (pg 11/18). Canlan’s share price from Google is $3.83. So price to book is ($3.83 * 13.3M) / $43M = 1.2x. As a rule of thumb, if a company trades above 1x P/B, this means that the company’s return on equity is greater than its cost of equity. If you want to know more, Google the search term “justified price to book”. It is odd that Canlan trades above 1x P/B given the poor return on capital it earns.
For EV/EBITDA, we already know net debt is $43M. We can add this to market cap of $51M (share price of $3.83 * shares outstanding of 13.3 million) to get to enterprise value of $94 million. We also know from the balance sheet section that last twelve months EBITDA is $12.6M. Putting the two together EV/EBITDA is 7.5x ($94 million / $12.6 million). In today’s market, you have high quality companies that trade high-teens to low-twenties EV/EBITDA (but note these companies would be earning a much higher return on capital in general which should mean you will pay a higher multiple of current earnings / cash flow).
For P/E, I estimate an adjusted LTM EPS of $0.25. I feel like I have already walked through enough calculations for one post; so I will pass on this one. Email me at firstname.lastname@example.org if you want more information. This gets us to a P/E ratio of 15x (share price of $3.83 / $0.25). Again relative to the overall market, this seems cheap. But I am do not have a sense if you would say Canlan is cheap relative to other companies that earn a similar low return on capital.
Management appears to be honest and experienced. Balance sheet is stretched, but within reason given the nature of the company. The return on capital is too low for me to consider Canlan an investment candidate. Valuation looks attractive without taking the low return on capital into account.
Where I could be wrong
It is interesting that the major shareholder of Canlan is a real estate company. It is possible they think there is a higher and better use for the land the arenas that Canlan owns are on. Bartrac is simply collecting a small coupon while they wait for a condo developer to come make them an offer they can’t refuse. This would require doing a whole lot more work on the neighbourhoods’ of the arenas and the developments around them. Not something I have much interest in doing at the current time.
The Company’s website: https://www.icesports.com/
Author Ownership: No TSX: ICE
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