Where Food Comes From (OTC: WFCF): A Balanced Opinion


The next post I have written is on Where Food Comes From (OTCMKTS: WFCF). I have took a little bit of a different approach in writing this post. I have not completed my work on the company, but I think I have got to an important junction where it would be helpful for both myself and my readers to express my thoughts. The goal is to start an open dialogue. I have grown very sick of a lot of both sell side and hedge fund research that is totally one-sided (based on whatever position they are taking). My aim here is to provide balanced commentary that acknowledges opportunities and threats. It has always been my intention to be balanced, but something I will strive to do even more so in the future.

Why I started looking at WFCF?

The root of the idea came from listening to a podcast between Meb Faber and Dan Rasmussen found here. Rasmussen is an interesting speaker. His primary thesis is that ‘private equity’ only did well in the 80s and 90s because they bought assets very cheap and leveraged them up; private equity’s ability to provide operational expertise and increase business value is limited. Rasmussen believes assets being bid on by private equity are no longer cheap; there are too many bidders. Therefore, future private equity returns will not match what the asset class has done historically. His belief is that you can instead earn excess returns by instead buying publicly traded small cap companies that have attractive valuations and high leverage, as long as they use all of their excess cash flow to reduce leverage.

While the strategy makes some sense to me, my view is that the downside risk is much too high for me to be able to justify it at this point in the cycle. I do not have the appetite to buy heavily indebted stocks with low levels of liquidity. However, it did get me thinking… My thinking was along the lines of while I do not necessarily want to try to replicate a private equity strategy with publicly traded micro to small cap equities, are there any other types of strategies that could be worthwhile replicating? My thoughts turned to venture capital. Maybe there is a group of publicly traded micro to small cap companies that are aggressively growing the top-line, but have not yet reached profitability. Since they are likely underfollowed, they could trade at attractive valuations.

WFCF seemed to fit this bill quantitatively. The chart below shows WFCF’s history of sales, EBIT and free cash flow. While sales have grown strongly, WFCF appeared to be driving all of its profit back into further sales growth.

What does WFCF do?

WFCF provides third party verification and certification solutions for agriculture, livestock and food industry. Claims like gluten-free, non-GMO, non-hormone treated, humane handling require verification for credibility. WFCF provides this verification through onsite and “desk” audits to verify that claims being made are accurate.

In 2017, WFCF’s revenue mix was ~80% verification/certification, ~10% software (from acquisition of SureHarvest) and 10% product (mainly ear tags for cattle).

Market Cap

WFCF has 25 million shares outstanding and most recently traded at $2.15 per share, giving it a market capitalization of $53 million.


The opportunity that WFCF has is fairly clear. Consumers are increasingly demanding transparency in all facets of their life, food included. They want to know where their food came from and if suppliers along the value chain act in a sustainable manner. This has opened up lots of opportunities for WFCF to certify claims made by suppliers. Additionally, food has faced increasing regulatory burdens – an area where WFCF can again assist.

Another opportunity lays in the structure of the industry. According to Bureau Veritas, the testing, inspection and certification (TIC) markets related to agriculture and food are highly fragmented (see table below). Bureau Veritas also discloses a TIC market size for Food & Agriculture of 23 bn EUR. All this to say, WFCF operates in a market that is both large and highly fragmented. This could present an opportunity for WFCF to continue to use M&A to drive consolidation in the industry.

The last opportunity I will mention is that WFCF currently spends 40-45% of sales on SG&A. This is high. As WFCF increasingly becomes larger, it could be possible that its sales force becomes more productive. As WFCF grows, their presence and reputation also grow, meaning they could potentially begin seeing more inbound inquiries. This would likely result in higher productivity per sales person as more time could be spent on real prospects rather than cold calling. And as a result SG&A as a % of sales would decrease.


There are some large public companies that operate in the broader testing, inspection and certification industry (“TIC”) that can act as a comparable to WFCF. They are SGS, Bureau Veritas, and Intertek. Given the nature of the industry, the major expense for each company is its employees. In the case of WFCF, their service is for one of their employees to show up at a farm or call the farm (depending on the audit type) to verify that the requirements for a third party certification are being met. In this business model, the amount of sales/employee is critical. The more the better.

The amount of sales that each WFCF employee produces relative to the three major comparable public companies is striking (WFCF at >$250K vs Big 3 at <$100K). One driver of the large difference is where the employee base is located. All of WFCF employees are in the United States versus a mix of developed and developing countries for the three comparables. Employees in developing countries earn much less so it makes sense that they can also produce less revenue on a per employee basis and still be profitable.

We can correct for this ‘location of employee’ bias by looking at recent acquisitions the Big 3 have made in developed countries.

  • Intertek. Acquired FIT Italia in Dec 2015. 15 Employees and 2M EUR (USD $2.37M) of sales. Sales / Employee = $156,000.
  • SGS. Acquired Vanguard Science in Jan 2018. Sales of US$11M and 95 employees. Sales / Employee = $115,789.
  • Bureau Veritas. Acquired Maxxam in 2013. Sales of CAD240M and 2500 employees. Sales / Employee = C$96,000.

The magnitude is reduced, but WFCF still earns much higher sales/employee than the recent acquisitions of the Big 3. This could be a good thing. But in order for it to be a good thing, we must believe that WFCF is able to do something that the big 3 is not.

For example, it’s possible that WFCF operates much ‘leaner’ than the big 3 and has a very skinny overhead structure. This is likely true, although I find it difficult to believe that it could account for such a large magnitude. I’d note that in general businesses whose major expense is ‘service employees’ are much easier to run when they are smaller. The founder/owner mindset or culture is much easier to transmit to frontline employees when the company is very small and there are not many layers. I’d note WFCF has a husband/wife team that run the company as well as own a large chunk of the shares.

Another possibility is that WFCF has better IT and systems allowing its employees to be more productive. While this could also be true, I have a harder time believing it will be sustainable. Any advantage from WFCF likely stems from a first mover advantage. WFCF’s Big 3 competitors have a very large resource in terms of their capacity to spend on technology/software and I would expect them to catch up.

Another possibility is that WFCF is better at ‘bundling’ certifications and selling more than one certification per site visit or audit. This would result in sales per employee being higher. I also question sustainability here for the reason that the Big 3 competitors own all of their own testing labs. This means that WFCF services are limited to visual inspection or what the human eye can see. Their Big 3 competitors can go a layer deeper and offer services involving analysis beyond visual inspection (ie. DNA testing, identification of microbes, nutritional labeling, etc.). To me this would mean WFCF could be susceptible to being “out bundled” by their larger competitors who can offer both lab analysis and visual inspection/certification as part of the same package.

There is also a threat that could explain the large difference in revenue/employee. It could be that WFCF charges a too high a price for their services and will be forced to lower it in the future to retain its customers. My impression is that many retailers and suppliers have been scrambling to get their food certified as ‘organic’ or ‘hormone free’. In this scramble, they have prioritized speed over cost. Most retailers now have access to organic foods that were previously only offered in a specific vertical (ie. Whole Foods). Now that they have figured out the availability issue (ie. they have figured out how to get supply), they will likely start slowly turning the screws on price and suppliers including WFCF could get squeezed.



  • Tailwind from consumers demanding transparency and greater regulations;
  • Large, fragmented market provides consolidation opportunities;
  • Sales force could become more productive once brand becomes better known;
  • Operators are also owners;
  • Labor intensive businesses are easier to operate/execute when small;
  • First mover advantage leads to better IT/systems;
  • Leveraged strength in beef verification to cross-sell other certifications.


  • WFCF may have taken advantage of their customers with high prices while they were prioritizing speed to market over cost.
  • Large competitors have resources to catch up and eliminate any first mover advantages (ie. there is not a feedback loop that improves WFCF product because they have more data).
  • There is a risk that WFCF’s “bundle” is not large enough as they do not own laboratories. Big customers who own labs could offer a better “bundle”.


WFCF is currently trading at 3.5x revenue with limited profitability. This multiple may actually be a bargain if WFCF can turn into a software company that can show increasing returns as it scales up. However, this would be a big leap given 80% of sales are still coming from certification/verification which is a very labor intensive business. In the certification/verification business, WFCF cannot add sales without adding cost (ie. employees). This is not true in software where code is written once and has only very small costs to scale. For more on software and increasing returns to scale, here is a great podcast.

Author Ownership: NO OTCMKTS: WFCF

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with Where Food Comes From, Inc. nor has it received any compensation from Where Food Comes From, Inc.  for the preparation or distribution of this article.

The author may trade shares of Where Food Comes From, Inc. through open market transactions and for investment purposes only.

CCA Industries (NYSE:CAW): Undemanding Valuation; But I Lack Confidence in Growth Outlook

Company Overview

CCA Industries, Inc. (CCA) is a consumer products company with the following sales mix:

As can be seen, CCA’s key categories are Skin Care and Oral Care.

CCA’s Oral Care category comprises solely of the Plus+ White brand. The main Plus+ White product is a gel used to whiten teeth which is priced an order of magnitude below Crest Whitestrips (ie. $5-6 vs $40).

The annual sales trend of Oral Care can be seen in the chart below. The declines in recent years are largely attributable to CCA discontinuing the production of toothpaste. CCA has cited intense price competition between Colgate and Crest in toothpaste.

CCA’s Skin Care category is comprised of multiple brands. The two largest brands are Bikini Zone and Sudden Change. Bikini Zone’s main benefit is to prevent razor burn in “sensitive” areas. Sudden Change promises to reduce under eye circles. Porcelana (a licensed brand) is also included in the category and growing at a high rate. Porcelana’s main benefit is to even skin tone and reduce the appearance of “age spots”.

The annual sales trend in the Skin Care category is in the chart below. Recent declines can be attributed to discontinuing to Solar Sense (due to lack of profitability) and reducing the number of Sudden Change SKUs.

Why I looked at CCA

I got interested in looking at CCA Industries because it operates in a noncyclical industry (a prerequisite for me at this stage in the cycle) and has a very undemanding valuation.


The key factor in determining CCA’s future share price will be the trajectory of its top-line growth. This is something I struggle with given CCA’s low price positioning and threat of private label substitution in an increasingly competitive retail environment. I wrote out my thoughts in some detail – you may disagree… If you disagree, the valuation definitely seems undemanding and could be a set up for good returns in the future. I have some trouble trusting management given the obsession with share price and why it is not higher (makes me wonder what they would say / selectively disclose in order to try and increase the share price).


The Chairman and CEO of CCA Industries (CCA) is Lance Funston. Funston was named Chairman in Aug 2015 and became CEO in Jan 2016. Funston has a control ownership position in CCA which stems back to a transaction in Sept 2014 in which he: 1) acquired 100% of the Class A common shares, 2) a warrant to purchase 1.9M shares of common stock (exercise price $3.17), 3) Lent CCA a $1M term loan (LIBOR +6%), and 4) provided CCA with a $5M line of credit (LIBOR +6%). In March 2018, Funston exercised 450,000 of his warrants providing the company with $1.4M in cash which is intended to help launch new products. (Note: Class A and common shares are equal in nature other than the stipulation that Class A common shares separately elect 4 directors and common shares separately elect 3 directors).

Sardar Biglari (Lion Fund and Biglari Holdings) owns 776,259 shares of CCA common stock. Shortly after the 2014 transaction, Funston entered into an agreement with Biglari giving Biglari the right to sell him his shares at $6.00. Funston did this in an attempt to lock-up the largest shareholder and prevent further selling pressure on the stock. The right becomes exercisable on Jan 1, 2019 and is very likely to be exercised given CCA’s current share price of ~$3.00 (ie. Funston is on the hook to buy shares at $6.00 even though the current share price is only $3.00).

Funston is currently 75 years old and as he says himself, “it’s not my first rodeo.” Some of his past successes include Larami Toys which developed the Super Soaker, and TelAmerica which was sold to Cross MediaWorks (85% in 2008) and Lee Group (15% in 2013). Funston also founded Ultimark in 2000 which sold the Prell, Denorex and Zincon brands to Scott’s Liquid Gold in 2016 for $9.0 million. Ultimark continues to own the Porcelana brand which is currently being licensed to CCA (CCA pays Ultimark a 10% royalty on gross sales).

One unsettling claim from Funston is that he sold the Prell, Denorex, and Zincon brands for 3x sales to Scott’s Liquid Gold. Based on SLGD disclosure, the brands were actually sold for only 1.4x sales ($9 million purchase price on $6.5 million of sales).

The dealing/licensing between Ultimark and CCA also raises an eyebrow as Funston is Chairman of Ultimark and control owner of CCA. This is compounded by more self-dealing as Funston also earns fees for CCA Industries advertising (through Funston Media Management) and owns a building that CCA rents.

The other named officers are Douglas Haas who is COO and Stephen Heit who is CFO. Heit has been at the company since 2005 and provides Funston with some “institutional knowledge” that he may otherwise be lacking. Funston brought Haas into CCA in 2015. Haas previously worked with Funston at Ultimark since 2015.

What concerns me the most is Funston’s obsession with the share price on the conference calls. When management is too concerned with the short-term share price, they may take actions that hurt the sustainability of the business over the long-term. They also become difficult to trust and take their word at face value; as demonstrated by Funston’s claim that he sold the brands to SLGD at a higher multiple than he did.

Balance Sheet

As at 28 Feb 2018, CCA Industries had $1.5M of debt outstanding and a cash balance of $1.1 million. Net debt of $0.4 million. This is down from net debt of $1.9 million at year end 2017 and $3.0 million at year end 2016. Note that CCA Industries saw a $1.4 million cash inflow from Funston exercising warrants in Q1/18 which accounts for the majority of the change in net debt between y/e 2017 and Q1/18.

In the years 2013 and prior, CCA industries typically operated with a large net cash balance. This changed in 2014 largely from fallout related to returns in two of their product lines: 1) Gel Perfect nail care products, and 2) Mega-T diet supplements.

It is important to note the trend in CCA’s debt agreements. Over time, terms have become less punitive. Most recently, CCA went from paying LIBOR +6% on an agreement with CNH Finance to paying LIBOR + 2.75% with PNC bank. In other words, debtors have re-rated the credit risk associated with CCA industries. This is in large part due to CCA’s increased profitability and associated cash flow in 2016 and 2017.


While I wholly disagree with blindly extrapolating growth rates forward to forecast target share prices, it is still very useful to know the historical performance of a company. CCA’s Net Sales and EBIT are displayed in the chart below. Two things to note:

  1. The displayed results do not include the Gel Perfect nail care brand or the Mega-T dietary brand; both of which were discontinued in 2014.
  2. While net sales have been in decline, CCA has done an impressive job at increasing profitability. This has been done by outsourcing all manufacturing and order processing. Payroll at CCA has gone from $11 million at its peak to $2 million currently. CCA has also trimmed the number of SKUs it carries to focus on its most profitable lines.

The key question in my mind is whether or not CCA can return its top-line to growth. This is obviously not a unique insight given that nearly all “turnaround” situations face this dilemma. But nevertheless, it is still very important to analyze…

One important note in making this assessment is that CCA does have major customers with Walmart at 36% of sales, Walgreen at 13% of sales, and Target at 7% of sales. It’s also important to note that sales have been on a decreasing trend at each of these major customers. The implication being that CCA is losing shelf space.

In my view, the positioning of CCA’s brands as low cost leaders within their categories is troublesome. Brands at the low end of the price spectrum are most susceptible to private label competition. I would note for example that CVS Pharmacy has a “store brand” for teeth whitening that looks to have a similar function to CCA’s Plus+ White brand. Private label is playing an increasing role in US retail due to the entrance of Aldi and Lidl.

In order to reverse the trend and sell more to its large customers, CCA needs to innovate and introduce new products. There are some promising developments on this front: 1) CCA’s Bikini Zone brand has four new products (exfoliating gel, ingrown hair syrum, medicated pad, depilatory), 2) CCA plans to extend its Bikini Zone product to males with a trademark known as “Manscape Grooming”, 3) Porcelana brand is introducing a new hand cream, and 4) Plus+ White has a new product specifically targeting sensitive teeth.

If CCA is not able to convince retailers to carry its new products, the company does have potential to sell direct to consumer through e-commerce. On a related note, CCA has committed to increasing digital advertising to 50% of its media spend in 2018.

I estimate CCA’s largest brands are: 1) Plus+ White at $7.5 million of sales, 2) Bikini Zone at $3-5 million of sales, 3) Sudden Change at $3-5 million of sales, and 4) Porcelana at $2 million of sales. Add it all up, and these brands represent nearly 90% of CCA’s sales. Further, CCA has noted Plus+ White and Bikini Zone are “Millennial” brands where things like social media presence matter.

We can take a look Plus+ White and Bikini Zone’s online presence to gauge their likelihood for e-commerce success.

Amazon Star Rating

Like it or not, the star rating generated by consumer reviews on Amazon matters.  Depending on the exact product, both Plus+ White and Bikini Zone have reviews that range between 3.5 and 4.0 stars on Amazon. I would classify this as “okay”. Generally, you need at least a 4-star product to show up on the first page of Amazon search results.

Instagram Followers

Both Plus+ White and Bikini Zone have about 20,000 Instagram followers. This is good when compared to a brand like Crest which also happens to have about 20,000 followers, but small relative to brands that have been built on social media like Quest Nutrition (813K followers), The Honest Company (812K followers) and StichFix (654K followers). The engagement of both brands seems relatively limited. Plus+ White averages 50 to 100 likes per post, while Bikini Zone can get up to 200 likes (which still seems low given over ½ of its posts are attractive females in bikinis).

YouTube Influencers

Plus+ White has better traction than Bikini Zone on YouTube.

There are three Plus+ White “influencers” I found on YouTube promoting Plus+ White. The videos have 5.2 million views (https://www.youtube.com/watch?v=u_M5MaxLL5U), 709 thousand (https://www.youtube.com/watch?v=2pFAr6hgIEM&t=2s), and 252 thousand views respectively (https://www.youtube.com/watch?v=jtlI4nUuPf8).

I found one Bikini Zone “influencer” whose video has 1.5 million views. (https://www.youtube.com/watch?v=glRP_kq3CDg).


While promising, CCA’s online presence still appears to be in its early stages. It will be interesting to see how numbers increase in 2018 as CCA puts more dollars behind digital ad spending. It is worth pointing out that Funston’s expertise is in aggregating local cable operator TV spots in order to reach a national audience. I am not entirely sure that this will translate into the digital world (while also noting that CCA continues to use Funston Media Management – owned by Lance Funston – as its advertising agency).

A couple of final points on growth which I have yet to mention:

  • CCA recently announced a change to its third party sales and distribution organization. CCA is switching from Emerson to Advantage because Advantage has a larger presence in grocery and internet channels. The grocery channel represented $3-4 million in sales for CCA at one point; most of which has been lost.
  • CCA is hopeful it can reinvigorate the nail care category which used to sell $4-6 million annually. CCA recently signed a new trademark agreement for the Nutra Nail brand with a 10% royalty and an option to buy. CCA plans to go back to market with Nutra Nail’s six core products which includes things like nail strengthener and cuticle remover.


According to Funston, the going price for CPG companies in M&A transactions is 3x net sales. Using his metric, CCA is undervalued at around 1x net sales. No need to do any further work right? If only it were that easy… I would view Scott’s Liquid Gold (OTCMKTS:SLGD) as one of CCA’s closest comparables. In 2017, SLGD earned revenue of $42M and EBIT of $7.6M. At a share price of $3.35, SLGD currently has a market capitalization of $40.3M and an enterprise value of $37.3M, or a P/S ratio of 0.95x and a EV/EBIT ratio of 4.9x. Based on 2017 sales of $19.8M, EBIT of $3.5M, CCA currently trades at a P/S ratio of 1.2x and EV/EBIT of 6.9x.

One possibility is that both SLGD and CCA are undervalued because of their size. For example, Church and Dwight currently trades at 3.5x P/S and 18.2 EV/EBIT.

Another important note is that while SLGD has grown, CCA has shrunk. SLGD increased revenues from $16M in 2012 to $42M in 2017. Over the same period, CCA Industries revenue went from $53M to $20M (or from $33M to $20M if you exclude CCA’s discontinued Gel Perfect and dietary supplement products). It is possible that the difference in valuation is implying that CCA is expected to outgrow SLGD in the future. This seems reasonable given a significant portion of SLGD’s growth has come from their agreement to distribute Batiste Dry Shampoo. This could provide a headwind in the future as the ownership of Batiste changed in 2011 to Church and Dwight (from Vivalis who is based in the UK). It made more sense for SLGD to distribute the brand when it was owned by a UK-based company. Now that it is owned by a US company (Church and Dwight), the terms have already become more difficult. SLGD has been restricted to only selling in the specialty retail channel, and has also had the definition of what constitutes the specialty retail channel changed (ie. TJ Maxx was excluded from being considered “specialty” in 2017).

Another source of value for CCA relative to SLGD is tax loss carry forward. The carry forward should allow CCA to avoid paying cash taxes over the next 3-4 years (assuming profitability stays roughly the same). As of yearend 2017, SLGD did not have any tax loss carry forwards.

One last point to mention is that there could be some significant dilution if the CCA share price appreciates. There are 871,500 options outstanding with a strike price of $3.27 and 1,442,794 warrants with an exercise price of $3.17. This is significant relative to CCA’s total shares A (common + Class A) of 7.9 million.

The Company’s website: www.shopcca.com/

Author Ownership: NO NYSE: CAW

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with CCA Industries, Inc. nor has it received any compensation from CCA Industries, Inc.  for the preparation or distribution of this article.

The author may trade shares of CCA Industries, Inc. through open market transactions and for investment purposes only.

McRae Industries (OTCMKTS: MCRAA): If cash on the b/s is unlikely to be paid out, does it still exist?

Those of you who have read my previous posts know that I have not had a whole lot of luck looking at stocks in the Canadian market as of late. I decided to expand my search into the USA. My first write up is on McRae Industries (McRae). McRae Industries has a market cap of US$84M.

I will note right off the bat that McRae trades on the pink sheets in the USA under the ticker MCRAA, which means it does not file financial statements with the SEC. The company has not filed with the SEC since 2005 when it ceased doing so in an effort to reduce costs. McRae still posts audited financial statements with Grant Thornton being its auditor for the past 10+ years.

Mcae Industries imports and sells western and work boots, as well as manufactures and sells military combat boots. The key point of distinction being that McRae manufactures military boots, while the company designs and imports western and work boots leaving the manufacturing to a third party. McRae was founded in 1959 and is most well known for its Dan Post brand of boots. McRae is headquartered in Mt Gilead North Carolina which is about a 1.5 hr drive from Charlotte.

Previous blogosphere write-ups on McRae include one at OTC adventures and another at Oddball Stocks. I think this post will add to the conversation by providing more detail around potential growth and valuation.

Let’s put McRae through my screen of: 1) Capable management teams and board, 2) Strong balance sheet, 3) Profitable growth, and 4) An attractive valuation.

1)      Management and Board

McRae has two classes of shares. Class A shares elect two directors as a separate class while Class B shares elect 5 directors. On all other matter, Class A shares get 1 vote and class B shares get 10 votes.

As mentioned above, McRae no longer files with the SEC meaning we no longer get share ownership data. As of McRae’s last filing date in 2005, the McRae family owned 40% of Class A shares and 60% of class B shares and controlled 53% of all votes.

For the same reason (ie. McRae not filing with the SEC), we do not currently have data on executive pay. In 2005, Gary McRae (President) was paid ~$250K while the four named executives were paid a cumulative ~$800K.

I assume that the McRae’s have maintained their ownership, while it is likely that pay has increased as net income has increased.

My view is that the McRae family communicates with shareholders in an open and candid manner. This boosts my confidence in the quality of the management team. One example is how Gary McRae has communicated about trends related to Western boot sales. The excerpt below is from the 2014 annual letter which came before Western boot sales peaked in 2015:

“We see our western/lifestyle segment in a state of change. The women fashion consumers who have driven the market in this business over the past few years are becoming more price conscious. Because of this, we see more of these consumers moving from the Dan Post brand to the popular priced Laredo brand boots. We will be introducing our new line of men’s, women’s and children boots at the Denver WESA show in January 2015 and are excited about the designs we have to offer. To some extent, we expect the revenues in this segment to be down from previous years as the market adjusts to these changing boot preferences.”

Gary McRae literally warned shareholders of an upcoming challenging environment. This is unheard of in today’s era of fast-talking, free-wheeling management teams. Most management teams keep problems hidden until they get so ugly they can no longer be disguised. This is similar to a teenager with an enormous pimple. When the pimple first appears and is small, the teen has no shame in using a bit of cover-up to hide it. But at some point the pimple get so friggin’ huge, that the teen admits defeat and exposes it to the world as any more cover-up would make their face more orange than Donald Trump’s.

In short, McRae communicates with their shareholders like they are partners. For this reason, they have gained my trust and a vote of confidence.

2)      Balance Sheet

Some may call it “overcapitalized” or “lazy”, but to me, McRae’s balance sheet is pristine. Similar to a ski mountain early in the morning before first tracks have been made, McRae’s balance sheet has not been disturbed by anyone. No banker or anyone even acquainted with a banker has made their way near this balance sheet.

McRae has a relatively small market capitalization having grown from ~$30M 10 years ago to ~$84M today. Despite this small market cap of $84M, McRae has nearly always maintained a double digit net cash balance.

Astute readers will notice the large ramp in cash between 2016 and 2017. A natural question is what caused the cash increase and will it be permanent.

The chart above makes it clear the surge in cash was due to a large reduction in working capital. Cash flow before changes in working capital (blue line) has remained relatively stable, while cash flow after changes in working capital (red line) has surged. In the case of McRae, the specific reason is a reduction in inventory. A large portion is due to a reduction in military inventories. I expect this to be sustained as military sales are now on the decline. This could change if McRae wins new military contracts.

3)      Profitable Growth

In the chart below, you can see the top line (purple) has flattened out over the past four years. This is largely due to sales in the Western category (blue line). An offset has been military (green line).

Although it does not show up in the chart below, Military sales are currently rolling over hard as the company has yet to fill lapses in old contracts with new contracts. Military is on pace in to be down ~45% y/y in FY18 (y/e August). To put this in context, Military sales could fall from their level of $46M in FY17 to ~$25M in FY18 if McRae does not announce new contract wins.

My expectation would be that McRae will continue to win new military contracts, although overall levels could continue to be lumpy as we are currently seeing. I say this because of the nature of government contracting. The government has legislated that 23% of all government contracting dollars should be awarded to small businesses. McRae qualifies as a small business as it has less than 500 employees. Further, McRae has an even further advantage as some of its manufacturing capacity is located in a ‘HUB’ zone (historically underutilized business zone).

On Western, the trend in segment sales looks bad. However, numbers need to be viewed in the context of a broader narrative. I would be concerned if McRae sales were down while the rest of the industry were flat or gaining (ie. McRae was losing market share). In order to find out if this is the case, the next step is to figure out who McRae’s competitors are and their respective sales trends.

McRae’s largest competitor is the company that owns Justin and Tony Lama boots. This company happens to be Berkshire Hathaway. Given the boots are a very small part of the much larger conglomerate, disclosure is non-existent.

McRae has another competitor that is a public company named Rocky Brands (NASDAQ:RCKY). Rocky is a much better comparison because similar to McRae, it only produces boots. There is a slight difference in that the majority of Rocky’s sales come from work boots ($110M) and Western Footwear is a secondary category ($39M of sales). Rocky also has a significant military business $38M of sales).

As mentioned above, I would be concerned about McRae’s competitive position if they were shrinking in their sales while their competitors gained. The chart bellows show McRae’s Western sales (Blue line), relative to Rocky’s (red line).

McRae rose faster than Rocky’s, but it has also shrunk quicker. I attribute this to McRae, or more accurately Dan Post, having a stronger brand in the marketplace than Rocky’s Durango brand.

One reason I say this is due to the trend of Durango’s high and low price points over time (available in 10-K).

In the chart, you can see that Durango experimented with a high price product line (red), but it failed and prices were quickly restored back to near previous levels. On the other hand, the low end of Durango’s product line (Blue) has continually seen price reductions.

Western Boots went through a boom between 2012 and 2014. During a boom, consumers are less price sensitive and more sensitive to brand and style. When consumers placed a higher weight on brand and style, McRae won relative to Rocky (as averaged in McRae’s higher level of sales between 2012 and 2014). However, as the fashion trend has subsided, consumers have become more price sensitive and have weighted cost as a higher factor in their purchase decision. Since McRae gained more during these boom times, they have lost more as consumers’ tighten their purse strings.

In summary, I do not think McRae has any structural impairment around their Western segment. I also think Military sales will eventually rebound with new contract wins. Overall, McRae is in a mature category, and I expect this to be the major determinant of their growth in the future. Sales will likely stop declining, but it is unlikely they exceed the low-single digit (LSD) to mid-single digit (MSD) range.

One last thing to note is Boot Barn (a major retailer of Western boots) recently reported a quarter with MSD same-store sales growth for the first time since mid-2015 (note the fiscal year is ended April 1). Boot Barn had been struggling to overcome the impact of the oil price collapse in late 2014. This reversal could bode well for McRae’s future Western sales trends. Given McRae is the manufacturer and Boot Barn is the retailer, it is logical that Boot Barn’s sales would turn up before McRae’s as Boot Barn is closer to the final customer. In McRae’s most recently reported quarter (Q1/FY18), Western boot sales were down 8%.

4)      Valuation

The judgement of valuation is often in the eyes of the beholder. Some will say timing the market is impossible, so why bother? Stocks return the most of any asset class over the very long-term, so you should always own them. If you believe this, then it follows that in picking individual stocks, it should only matter if one stock is “cheaper” relative to other similar stocks. Valuation in an absolute sense is not important. Or in other words, stock selection becomes a relative valuation game.

On the other hand, you may think that we are 10 years into a bull market so a stock’s valuation relative to its history is important. For the most part, all stocks are expensive relative to history, so why be invested? Valuations revert to the mean over long periods of time so there will be a better time to buy. You are willing to participate in the market but only in exceptional circumstances when you find shares that are both undervalued relative to peers, but also undervalued to where they have traded historically.

I do not wish to delve further into this argument and pass judgement as to which side is right in this post. However, I do help to provide perspective on both sides of the argument.

First let’s look at McRae’s valuation relative to history. The way to read the charts is that each year has a line with a dot. The top of each line represents the high in valuation for the year, the bottom of the line represents the low and the dot is the average valuation for the year. The green dot is where McRae currently stands based on my estimates for FY18. I have looked at this analysis for P/E ratio, EV/EBIT, and P/B. In short, each metric suggests McRae is near the high end of its valuation range relative to where it has traded historically.

So in an absolute sense, McRae looks expensive. The other way to think about valuation is how McRae trades relative to other public companies. As mentioned above, Rocky Brands is a close competitor so we can look at how the market is valuing McRae relative to Rocky.

On both a P/E and P/B basis, McRae looks to be priced at a similar level to Rocky. However, on an EV/EBIT basis, McRae is at a significant discount to Rocky. This is very interesting in my opinion. Both P/E and P/B ratios have share price in the numerator. This means that McRae does not get any credit for its large cash balance when using these ratios. On the other hand, EV/EBIT does give credit to McRae for its cash balance (see Appendix 1 if you need an explanation why).

This divergence in valuation metrics suggests to me that the market is taking the view that the cash within McRae is “trapped” because of the family ownership, and therefore should not have any value attached to it. This to me is short sighted. Cash has strategic value during recessions when financing is hard to come by and there are forced sellers in the market place.


The McRae family appears to be honest and competent operators; I am happy to be their partner. McRae has a very strong balance sheet; a point the market appears to be overlooking in its valuation of McRae relative to Rocky. While McRae’s Western business has been weak and Military business is expected to be weak over the coming year, I do not think either business is structurally impaired. McRae should be able to grow with the market at a minimum over the long-term.

Appendix 1: Industry Analysis

When first becoming acquainted with an industry I find it helpful to draw out a value chain of the different players involved in getting the final product to the end-consumer.

Some value chains do not have any excess profits associated with them. Others see the excess profits migrate to the single step in the chain that has the most power. In terms of Western boots, my opinion is that the designers and brand owners (ie. McRae, Rocky, Justin, Tony Lama) have the strongest position. An outline of strengths/weaknesses in each step follows:

Raw materials: Historically a very tough business. Most profits are earned during periods of short supply, but these do not last long as new capacity comes along and excess profits get competed away. Major raw materials are leather and rubber.

Contract Manufacturer: While reputation and reliability count for something, the premium that a contract manufacturer can earn will always be limited. McRae can do product tear-downs and will be able to know what a product should cost to manufacture. McRae’s business will be put out to bid with multiple contractors competing. McRae will always experiment with new sources of supply so that it can never be held captive by a single contract manufacturer.

Designer and Brand owner: This step of the value chain is relatively light on capital as the major investment is inventory. In order for the brand to remain relevant, the company must keep styles current and support the brand with marketing spend.

Retailers: According to Boot Barn (NYSE:BOOT), there are thousands of independent specialty stores across the United States that sell Western boots. Boot Barn is relatively small with 219 stores, yet they think they are 3x larger than their nearest competitor. This high level of fragmentation is advantageous to McRae and other manufacturers. Most of the manufacturers’ customers lack the scale necessary to backward integrate into brand ownership and manufacturing. This limits their ability to demand volume discounts and advertising support when bargaining.

A conversation about industry would not be complete without discussing the impact of technology. As consumers change their purchasing habits from on premise to online, there is risk that a dominant internet retailer of Western boots could emerge, develop its own brands and cut out brand owners by going direct to the contract manufacturers. In this case the new value chain would have one less step and look like this:

To some extent, Boot Barn is trying to do this with its growth strategy which includes both 1) increasing private label penetration from the current 11% of sales level, and 2) increasing sales done via e-commerce (demonstrated by their acquisition of Sheplers). There is not an immediate threat to McRae because Boot Barn still relies heavily on brand owners for logistics capabilities. Most of Boot Barn’s merchandise is delivered directly to their stores and they need brand owners for this capability. I’d also note McRae is positioned to benefit from private label as they exclusively supply Boot Barn with their El Dorado brand. More recently, Boot Barn announced “exotic” extensions to their El Dorado brand:

Given the importance of proper footwear fit, I view it as unlikely that a new brand will be able to emerge out of an online retailer. I view online purchases to be more likely from a brand that the customer is already very familiar with. For example, if they have a favorite boot and the sole has worn out, it will be easier to reorder the exact same boot at the exact same size online.

I’d also note that ‘authenticity’ is an especially important trait of Western boot brands. Dan Post for example is “Cowboy Certified”. Boot Barn’s motto is “Be True”. It is difficult for an upstart to have the same authenticity as a brand that has successfully appealed to American outback values for several years. This can be seen by the simple fact that there are not many new Western boot brands. The last major brand to emerge was Ariat in the early 1990s. They did so by competing at the high end, and focusing on first appealing to athletes competing in horse riding. Other Western brands and their inception date are listed below:

Dan Post – Mid-1960s

Durango – 1968

Tony Lama – 1911

Lucchese – 1883

Justin Boots – 1879

Stetson – 1865

The support for McRae having a strong position in the value chain comes from McRae having better return on capital than Boot Barn (their customer).

McRae also has better numbers than Rocky, its closest publicly traded comparable. A higher ROIC versus a competitor generally implies the company with a higher ROIC has a competitive advantage. They are able to do something that their competitor cannot. If their competitor could replicate their efforts, they would earn similar returns on capital. In McRae’s case, I think the higher ROIC is a result of a stronger brand.

While it looks like McRae has a lower gross margin, it is being weighed down by military having a very low gross margin of only ~15% and McRae having a higher mix of military sales than Rocky. McRae’s Western boots carry a gross margin of 34% and work boots have a gross margin of 35%. This is relative to the gross margin in Rocky’s whole sale segment of 32%. McRae having a larger gross margin than Rocky is consistent with McRae having higher prices points implying a larger brand premium. This difference in gross margin largely falls down through to a difference in EBIT margin. I’d also note McRae’s pre-tax ROIC number is helped by carrying less inventory on its balance sheet than Rocky.

Out of interest, I took a look at the numbers for a similar, but adjacent value chain. The numbers for Nike (NKE), Foot Locker (FL) and Finish Line (FINL) are below. My main takeaway is that one of the reasons the numbers for the athletic shoe value chain are so much higher is that the chain turns inventory much quicker than the Western boot chain. Players in the athletic shoe chain turn inventory 4x a year versus 2x a year for the Western boot chain. Nike has also done a good job at building its brand and extracts a price premium from the consumer which shows up in the gross margin line.

Appendix 2: Enterprise Value (EV)

 Enterprise value (EV) is defined as market capitalization (share price * shares o/s) plus net debt (total debt less total cash). Let’s use an example to illustrate. The company has: 1) 10 million shares, 2) a share price of $10, 3) Debt of $20M, and 4) cash of $10M. In this case, the company’s market capitalization is $100 million (10 million shares o/s * share price of $10). Net debt is calculated as $10 million (total debt of $20 million less $10 million of cash). So enterprise value is $110 million (market capitalization of $100 million + net debt of $10 million).

In McRae’s case, there is no debt and a large cash position, so the calculation becomes market capitalization minus net cash (rather than plus net debt). In the example above, let’s now assume $20 million of cash and $10 million of debt. So net debt would be -$10 million and EV would be $90 million (100 million market capitalization less the $10 million net cash position).

The Company’s website: www.mcraeindustries.com/

Author Ownership: YES OTCMKTS: MCRAA

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with McRae Industries, Incnor has it received any compensation from McRae Industries, Incfor the preparation or distribution of this article.

The author may trade shares of McRae Industries, Incthrough open market transactions and for investment purposes only.

Titan Logix (TSXV: TLA): Market Cap = Net Cash. But sometime’s a bad company, is just a bad company

Let’s start by running Titan Logix (“TLA”) through my initial screen of: 1) Capable management teams and board, 2) Strong balance sheet, 3) Profitable growth, and 4) An attractive valuation.

1) Management and Board

TLA appointed a new CEO in Feb 2016 named Douglas Carruthers. In Dec 2017, TLA announced Carruthers employment agreement will not be renewed and Carruthers will cease to be CEO as of 31 January 2018.

This quick change in CEO is usually a cause for concern and warrants deeper investigation. My conclusion is that Carruthers has been pushed out by the Board. Shortly after Carruthers was appointed CEO, The Jerry Zucker Revocable Trust (“Zucker Trust”) announced it was looking to appoint three directors. In April 2016, the Zucker Trust announced an agreement with Titan in which the Zucker Trust was able to appoint two directors and acquire 2.3 million shares.

The current Board of Directors consists of 4 people at TLA; two of which have been appointed by the Zucker Trust (Helen Cornett and Grant Reeves). Warren White (the third of four directors) also looks connected as both Warren White and Grant Reeves sit on the board of Circa Enterprises (TSXV: CTO). I believe the Trust did not want to renew Carruthers’ employment agreement for cost reasons. The current Chief Technology Officer, Greg McGillis, previously served as CEO at Titan and continues to be employed at Titan. My expectation is that there will not be a new CEO appointed. While the executives are not earning excessive compensation, my impression of the Zucker Trust based on this article is that they are very frugal and will not leave any stone unturned in search of cost savings.

The Zucker trust currently owns 25% of shares outstanding. There are no other 10% owners.

Given their track record, I would deem the Zucker Trust as capable. However, there is a question as to whether the Zucker Trust is aligned with the interests of minority shareholders. In a previous transaction, the trust came under scrutiny for paying $1.70 a share to take Galvanic Applied Sciences private. Prior to the offer for Galvanic, the shares were trading at $1.60 on the open market, meaning the premium was very small.

It is also worth noting that the two Board Members that the Zucker Trust appointed to the Titan Board were involved in the Galvanic Transaction (Grant Reeves and Helen Cornett).

2) Balance Sheet

TLA’s balance sheet is very strong. As at 30 Nov 2017, Titan had $6.5 million of cash, $2.0 million of marketable securities, and an additional $4.9 million owed to TLA by an energy services company in the form of a secured loan. TLA does not have any debt outstanding.

3) Profitable Growth

Recently, TLA has neither grown, nor been profitable. The company sells a single product which is heavily exposed to fracc’ing and shale oil. As such, they have seen revenue collapse from $17 million to the current level of ONLY ~$3.5 million; down a whopping 80%. The table below shows sales, earnings before taxes and EPS for the past 10 years.

4) Valuation

As at 30 November 2017, Titan Logix has a 28.5 million shares outstanding. Shares most recently traded hands at $0.50, putting TLA’s market cap at $14.3 million.

Titan has lost money in each of the past two fiscal years (TLA reports on an August year end) making earnings-based valuation measures difficult. Peak EPS was $0.15 in FY12 which is roughly 3.3x the current share price. It is highly unlikely that TLA will earn this amount again in the near future as the company benefitted from the massive build out of the shale oil industry, which is unlikely to repeat.

Another way to think about valuation is to look at assets. The total of TLA’s cash, marketable securities and secured loan is $13.4 million. This almost fully supports TLA’s current market capitalization of $14.3 million. If TLA can ever earn money again, then the current share price could be an attractive entry point.

TLA’s trajectory looks promising in terms of returning to profitability. After reporting a gross margin of 22% in FY16 and 33% in FY17, TLA reported a 47% gross margin in its most recent quarter (Q1/FY18). On a cash operating basis, TLA spent about $150K more than it earned in Q1/FY18. In FY17, TLA spent $809K more than it earned on a cash basis and in FY16 the same number was $2.4 million (excluding asset sales but including interest income).

When valuing companies on an asset basis, the rate of burning cash is important because the asset value deteriorates by the rate at which the company burns cash each quarter. Given the trajectory, TLA should return to profitability and start increasing asset value each quarter by the end of FY18 or early FY19.


Balance sheet is very strong. Based on the strong balance sheet, TLA also looks attractively valued given it is trading nearly at the same value of its cash, marketable securities, and secured loan. The Zucker Trust likely does not have the interest of minority shareholders’ in mind, but this may limit upside rather than increase downside risk which I am okay with. The big question to answer is whether or not TLA can become profitable. If it does not, the company will continue to burn cash, and the balance sheet will slowly weaken, and for lack of a better term TLA will likely be a “value trap”.

Return to profitability?

In order to determine if Titan Logix can become profitable again, we need some more information:

End-markets: Titan focuses predominantly on the upstream and midstream oil and gas industry. This market demands rugged and reliable equipment because the drill sites are often accessed via rough industrial roads.

Product: Titan’s core product is known as the TD80. Its use is in mobile tankers (ie. large trucks that carry fluid). The TD80 is one part fluid level gauge and one part overfill prevention device. The TD80 has no moving parts making it more durable than float-based mechanisms. In the year ended Aug 2017, the TD80 and the associated display generated 83% of TLA’s revenue. The key takeaway is TLA is a single product company.

Sales Channel: Titan sells to both the manufacturers of mobile tanks and the dealers who sell mobile tanks. Examples of tank manufacturers are: Mac LLT, Heil Trailer, Beall / Walker (owned by Wabash National; a public company), and Vantage Trailers. An example of Dealer is Shipley Motor Equipment in Arizona or Bruckner’s Truck sales in Texas. It is worth nothing that Wabash (owner of Beall/Walker) thinks its tank trailer sales will be up 10-15% in 2018, but this is after being down 35% in 2016 and down another ~10% in 2017. I’d also note that Beall/Walker has significant exposure to dairy, food and beverage end-markets that TLA does not.

End-user: The end buyer of Titan’s TD80 product is often oil companies themselves. Unlike in over-the-road truck transport, the end-user (ie. oil company) is often the owner of the truck rather than a third party logistics/transportation company.

Intellectual Property: It is unclear how much intellectual property is proprietary to TLA. TLA notes in its annual report that it has a license agreement with Lawrence Livermore National Laboratory and pays a royalty of 3% of TD80 sales. The license agreement remains in force until Feb 2018 when the last patent expires. TLA talked about filing its own patents in FY14 and FY15 but it is unclear if these have been incorporated into any product. Titan paid royalties of $79,199 in FY17.

Rig count: Given TLA’s focus on upstream/midstream oil and gas end-markets, the Rig Count in the United States is a very important indicator. As can be seen, while the number of rigs has increased from the lows, it is still materially below 2015 levels. In my view, this means there is still a significant amount of equipment or “kit” that is sitting idle. This is likely to depress sales in the near to medium term.

Retrofit:  Given depressed new tanker sales due to idle equipment, TD80 has turned attention to gaining sales in the retrofit market. The table below is from Wabash National. It shows that the life of an Aluminum Tank is ~10 years while the life of a Stainless Steel tank is 15-30 years. Given that the TD80 is a solution meant for “rugged” applications with no moving parts, I would expect it also has a relatively long life. This limits the amount of retrofit opportunity available to Titan.

Competitors: TLA has a number of competitors that also offer tank monitoring solutions. TLA is unique because of the technology used in its product called Guided Wave Radar (“GWR”). The only other company to offer GWR is Vega (www.vega.com). I do not view Vega as a competitive threat because TLA actually sells some of Vega’s product within its “stationary tank gauging” assortment listed on TLA’s website. It is unlikely TLA would sell product of a company that it views as a competitor.

Other TLA competitors include:

Scully Signal (www.scully.com): Scully offers a overfill protection system which relies on an optical sensor. The optical sensor has a binary output. It is either wet or dry meaning the tank is either full or still has room. Optical sensors do not offer level gauging like GWR does. GWR can tell you whether a tank is 33% full of 55% full.

Garnet Instruments (https://www.garnetinstruments.com/): Garnet sells a product known as the SeeLevel tank gauge which is based on a “Float” system. GWR has advantages relative to float-based systems. Fluid movement in the tank during transport can set off an overfill warning in a float-based system. Floats can also get stuck and do not measure properly if tank is not cleaned/maintained properly.

There are a number of other competitors also using some combination of floats and optical sensors for overfill protection including: Micro-design (http://www.micro-design.com), Civacon (http://www.opwglobal.com/; Owned by Dover NYSE : DOV), and Dixon Bayco (www.dixonvalve.com).

There are also a few competitors who specialize in underground tanks and leak detection: Tanknology (https://tanknology.com/) and Tank Tech (https://www.tanktech.com/).

Last, there are a number of company using sensors on stationary tanks or bins to send data up to the cloud which is then used to optimize transport routes: eCube, SmartBin, Atek Access Technologies, Enevo, SMARTLogix, Numerex (owned by Sierra Wireless; TSX: SW).

Growth Strategy

TLA is trying to return to growth by 1) Focusing efforts on adjacent end-markets (ie. outside of crude oil such as food, chemicals, etc.), 2) Emphasizing retrofit sales, and 3) Software allowing monitoring of driver performance, fluid level and weight inventories, alarm conditions and GPS location data.

I do not have a high confidence around any of these growth strategies.

In terms of adjacent markets, I think TLA had a great “product-market fit” with shale oil because of shale oil’s need for a rugged instrument and the high sensitivity around spills (TD80/GWR allows for multiple warnings at different fill levels). It will be difficult to expand into other applications as there are already entrenched competitors that know the needs of the specific application better than TLA.

In terms of retrofit, I think the opportunity is limited given TD80 has a relatively long product life.

In terms of software, I am not sure there is a valid value proposition that customers will be willing to pay for. I would like to see more “reference” customers before making this bet.


Titan has a single product that is dependent on the crude oil market. It is likely that Titan’s end-market in 2018 will be better than 2017. However, any improvements will likely only be marginal as there is still a lot of idle equipment that needs to be worked through. Titan has a unique technology, but it is coming off license in 2018. It is unknown if Titan has enough other patents to prevent competitors from entering Guided Wave Radar. I do not have confidence around Titan’s growth efforts outside of the TD80 and the crude oil end-market.

Titan is not a “quality company”. The fact that nearly all of Titan’s sales are from single product is bad. The fact that the product is coming off license and could be exposed to new competition is even worse. Not to mention that the product is dependent on a very cyclical end-market prone to boom-bust cycles. However, as I have said in other posts, a quality investment does not necessarily need to be a quality company.

Titan does not fit with my investment strategy.

Where I could Be Wrong

There is a possibility of an asymmetric risk/return payoff. It is hard to see things getting much worse for Titan. At the same time, TLA should return to profitability over the next 1-2 years. TLA’s market capitalization is almost entirely backed by cash, marketable securities, and a secured loan that Titan owns. In other words, Titan is being priced near liquidation value. If oil were to spike back up to US$100+, I would expect there to be another capex frenzy in shale oil as companies rush to prove out reserves. I do not think Titan is getting any credit for this “optionality” in its share price.

The Company’s website: www.titanlogix.com

Author Ownership: No TSXV: TLA

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with Titan Logix Corp. nor has it received any compensation from Titan Logix Corp. for the preparation or distribution of this article.

The author may trade shares of Titan Logix Corp. through open market transactions and for investment purposes only.

A Quick Look at Canlan Ice Sports (TSX: ICE)

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 qualitysmallcaps@gmail.com 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

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with Canlan Ice Sports nor has it received any compensation from Canlan Ice Sports for the preparation or distribution of this article.

The author may trade shares of Canlan Ice Sports through open market transactions and for investment purposes only.

Mediagrif (TSX:MDF): Does MDF pass the investment checklist?

A problem all investors face is allocation of time. We all only have 24 hrs, even Warren Buffet. In order to help my readers, I have structured my write up on Mediagrif in terms of how I think about optimally allocating time. I do a quick initial view and then I dive into the most pressing issue.

Initial View

There are four attributes I look for in my initial view: 1) Capable management teams, 2) Strong balance sheets, 3) Profitable growth, and 4) An attractive valuation. These attributes are often in conflict with one another. For example, it is easy to find companies with strong balance sheets and profitable growth, but at unattractive valuations. The art of investing requires finding the best possible mix of these attributes. How does Mediagrif stack up?

  • Management team. The CEO of Mediagrif is Claude Roy. Roy’s interests are aligned with shareholders as he owns 24% of shares outstanding. Prior to Mediagrif, Roy founded Logibec, a healthcare IT company. Logibec was bought by OMERS in 2010 for ~C$230 million. Upon becoming CEO at Mediagrif, Roy moved quickly to restructure and align MDF’s cost structure with its revenue base (ie. he laid off a lot of people).
  • Balance sheet. At 30 Sept 2017, MDF had $35 million of debt and $12 million of cash for net debt of $23 million. LTM EBITDA is $25 million meaning MDF is just under 1x net debt to EBITDA. MDF’s debt is held in a revolver and has not been termed out.
  • Profitable growth. Top-line growth has been flattered by acquisitions. Organic growth has been negative for each of the past five years. MDF has very little in the way of tangible capital in the business. However, it does have ~$175 million of intangible assets from prior acquisitions. MDF’s return on capital looks weak when including the intangibles from acquisitions.
  • MDF’s share price is down nearly 50% over the past year. Over the past four years, MDF has averaged about $20 million of free cash flow per year. This represents a ~13% FCF yield on its current market cap of ~$150 million. Earnings per share over the last 12 month EPS has been $0.79 for a p/e ratio of 13x.
    1. It is worth noting that MDF acquired a company called Orckestra in June 2017. Orckestra is currently losing money at an annualized rate of roughly ~$3 million pre-taxes. The LTM EPS of $0.78 only has two months of Orckestra losses. It’s likely EPS would be close to $0.65 if we projected Orckestra losses over a full year (ie. a P/E ratio of 15x). However, MDF says Orckestra will make a positive contribution within the next fiscal year so this may not be necessary.

Summary: 1) CEO has a good track record and owns a bunch of shares, 2) Balance sheet is okay, 3) Growth profile and returns on capital are relatively weak, and 4) Valuation looks attractive.

Next Step in Analysis: Deeper Dive on Growth

As I said above, it is rare  impossible to find a company that perfectly meets all four criteria in today’s market. So is the weak growth a deal breaker? Not necessarily. The stock market often takes recent growth numbers and extrapolates them forward. One of my favorite set-ups is finding a company where the market has assumed that weak recent growth will persist indefinitely into the future. In this situation, if you can correctly forecast that the company will return to growth, you can earn a healthy return. Based on MDF’s valuation, the market definitely appears to be assuming weak growth will persist. So the next step in the analysis is to determine if we think MDF will be able to grow in the future.

Track Record

Some sense of historical track record is necessary in order to predict the past. I find it helpful to look at top-line growth on both an IFRS and organic basis. In this case, IFRS includes revenue growth from acquisitions. The weak organic growth rate is a cause for worry. In my view, gaining confidence that the weak organic growth can be reversed is the key factor in deciding whether or not to invest in MDF.

Growth on a regional basis tells a similar story. The majority of growth has come from Canada which is where the large acquisitions have took place (ie. jobBoom and LesPac). Revenue has been falling in Asia/Europe, which I think is likely due to some sort of structural headwind at the Broker Forum and Power Source Online businesses.

The Business Model

Before we can figure out whether or not Mediagrif can return to growth, we have to know what the business does. I find an easy shortcut is to compare the business in question with a business you already know. For Mediagrif, I think a helpful comparison is Google. We all know what Google does. Google is a website that helps people find information they are searching for. While Google is a ‘general’ search engine, Mediagrif is a collection of search engines focused on specific verticals. Mediagrif also owns a collection of businesses that are more one-off in nature and do not fall within the search engine “bucket”. Within the search engine bucket, there are consumer-focused search engines and B2B focused search engines (if you would like individual business descriptions, please see the appendix):

  • Consumer search engines: LesPAC, jobBoom, Reseau Contact.
  • B2B search engines: Bidnet, ePipeline, governmentbids.com, Merx, Construction bidboard, Global Wine & Spirits, The Broker Forum, Power Source Online, Polygon.
  • “Other businesses”: Market Velocity, Carrus, Intertrade, Orckestra.

The number of businesses MDF owns makes the analysis of growth complicated. Especially given that MDF does not disclose individual revenue numbers for each business. We have to decide what to prioritize. Based on purchase price as well as disclosure around how much revenue the acquisitions added in their initial year, I estimate that the non-search businesses represent about 25% of MDF’s revenue on a going forward run-rate (ie. including Orckestra). I estimate the ‘consumer’ search engine businesses (ie. LesPac, jobBoom and Reseau) represent about 30% of sales and the b2b search engines represent about 45% of sales.

The Revenue Model

Continuing with the Google analogy, we can look at how each of the businesses earn money. There is a striking difference in that nearly all of Google’s revenue comes from advertising whereas nearly all of MDF’s revenue comes from “rights of use”. Within rights of use, Mediagrif includes packages of classified ads on LesPAC and recruitment packages on jobBoom.

Competitive Advantage

Within most software and e-commerce businesses, competitive advantage derives from network effects. Put simply, network effects mean the value of a product or service to a user goes up as more people use the product / service.

Google benefitted from network effects as they allowed Google to refine its search algorithm quicker than anyone else. The more people who use Google, the more information Google collects to make its search service even better. For example, if you search for “Dog Food” and the first site that pops up is pictures of dogs eating food, you will likely a) not click on it, or b) click on it then immediately bounce off of the site. Either way, Google gets valuable data to know that site of dogs eating food should not show up as the first rank when someone searches Dog food. Multiply this by the millions (billions?) of searches on Google each day, and you have a very valuable network effect.

Network effects in Mediagrif’s case are even more straightforward. For jobBoom, if there more jobs available that fit my skills, the site has higher value to me. For Bidnet, if there are more contracts displayed in my area that I should bid on, the higher the value of the site to me. And so on…

But the point here is not to define a network effect, but rather how you should act when you are in a business that is impacted by network effects. When a network effect is in play, the goal should be to build scale as quickly as possible. Once you have built scale, you go about figuring out a way to monetize it.

Mediagrif appears to have took the opposite approach with its businesses. Rather than build scale by offering an unbeatable user proposition, the company appears to charge heavily in hopes that the user base is sticky and will only churn slowly.

One example is LesPAC. LesPAC did not offer free posting of classified ads until March of 2017. This seems crazy given that Kijiji has been offering free classified ads since 2005. Not to even mention craigslist.org…

Another example is jobBoom. jobBoom revenues decreased by $0.7 milllion in FY17 due to price adjustments reflecting “market conditions.” Contrast this to indeed.com (owned by Recruit Holdings in Japan) who grew revenues by 62% in their most recent fiscal year. The key difference is that employers can post jobs for free on indeed. In fact, indeed even crawls websites to find jobs that are not voluntarily posted by employers. Indeed only makes money from employers who choose to pay to increase the visibility of their specific job postings.

Another big group of businesses owned by Mediagrif are the e-tendering businesses that help contractors find jobs to bid on. I would put Bidnet, ePipeline, governmentbids.com, Merx, and Construction Bidboard all in this bucket. Merx is a Canadian offering while the other offerings are focused on the USA. The American offerings have different tiers of service with governmentbids.com being the cheapest. A core component of these sites is an automated web-crawler that scans the websites of local, state and federal governments to find new bids or RFPs that have been released. The higher end offerings combine this with human research related to upcoming projects that have not yet been released (based on forecasts from aggregate budgets). The human researchers will also do things like find out who won similar jobs in the past and at what price to help optimize bidding strategies for their clients.

The automated web-crawler side of the business benefits from network effects similar to Google. The more contractors who use the service, the more data MDF gets to fine tune the web-crawler and make it the best one out there. The human side of the business benefits from scale. It is expensive to field a team of researchers. If you have scale, you can spread the cost of researchers over more users. This makes cost per user lower (or you can hire more researchers and keep cost per user the same but provide a better product). Within Canada, Merx is the largest provider and benefits from scale. However, in the United States, MDF is dwarfed by Deltek/Govwin/Onvia (all of which are owned by Roper). Since Roper is much larger and has more users, it can afford to employ more researchers and provide a better product at the same or lower cost than Mediagrif. There is also another well funded competitor in the space, Bloomberg Government. Not to mention a start-up with venture funding (ie. no need to make money immediately) – govini.com.

So I stopped…

As I mentioned at the start of this post, my strategy to optimize time is to do an initial view and then dig into the most pressing issue. In MDF’s case, the most pressing issue was their growth profile. The work above leads me to believe that MDF does not have any strong competitive advantages in a large portion of their businesses. Without confidence in their competitive advantage, it is difficult to make the forecast that MDF will return to growth. Without a return to growth, it is possible the stock could stay at a cheap/attractive valuation for an extended period of time.

Where I could be wrong

There are a few ways I could be wrong. One way is that the consumer businesses in Quebec could benefit from Quebec being a unique market from a cultural perspective. Mediagrif only needs to be the best in Quebec and does not need to worry about global competitors. My point would be that people in Quebec still use Google and ultimately the best site with the largest network effects will win, but I could be wrong… Another point could be that Mediagrif does not need to grow organically. They generate so much cash that they just need to keep a constant flow of new acquisitions and they will be okay. This business model is not for me personally. It feels unsustainable and a bit too much like Valeant. You also have to ask what type of talent they can attract to the company with this model… Last you could argue what is all this stuff about Google and network effects? Most of MDF’s businesses are much more like eBay as they resemble marketplaces. eBay does not make money on advertising; eBay makes money on their take rate based off of gross merchandise value. My response would be who has been more successful – eBay or Google?

Where else could I be wrong?

Appendix 1: Business Descriptions

Consumer “Search Engine” businesses:

  • LesPAC: a search engine specializing in helping users find pre-owned goods and local services (ie. classified ads)
  • jobBoom: a search engine specializing in helping users find job postings
  • Reseau Contact: a search engine specializing in helping users find other users looking for relationships

B2B “Search Engine” businesses:

  • Bidnet, ePipeline, governmentbids.com, Merx, Construction bidboard: search engines that specialize in helping contractors find relevant jobs to bid for. They also have software solutions for the buyer to streamline the bidding process. The different search engines above focus on different tiers of service (ie. price points) and geographies.
  • Global Wine & Spirits: a search engine helping buyers of wine and spirits find sellers of wine and spirits
  • The Broker Forum: a search engine for distributors and brokers to find other brokers and distributors selling electrical components. Also provides escrow and parts inspection.
  • Power source on-line: a search engine for dealers, resellers and brokers find other dealers, resellers and brokers selling IT and telecom parts. Has a supplier certification program.
  • Polygon: a search engine for buyers (retailers, suppliers, etc.) of gems and jewelry to find sellers.

Other “Search Engine” businesses:

  • Market Velocity: Market Velocity helps electronics manufacturers streamline their aftermarket support to customers by providing trade-in, recycling, and donation solutions.
  • Carrus: Carrus provides software to help auto mechanics and aftermarket parts distributors manage their businesses.
  • Intertrade: Intertrade helps retailers and their suppliers automate the ordering, fulfillment and billing process so that it can occur with minimum human intervention.
  • Advanced Software Concepts: ASC is a software tool to help businesses quickly and efficiently prepare and manage contracts such as RFQs (request for quotes).
  • Orckestra: Orckestra has a software solution to help retailers integrate their brick and mortar and digital solutions.

The Company’s website: http://www.mediagrif.com

Author Ownership: No TSX: MDF

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with Mediagrif Interactive Technologies nor has it received any compensation from Mediagrif Interactive Technologies for the preparation or distribution of this article.

The author may trade shares of Mediagrif Interactive Technologies through open market transactions and for investment purposes only.

DMD Digital (TSXV:DMG-H): Cheap – but what else?

This has been my hardest post to publish yet. I debated whether or not I should publish information on a company that does not meet my quality standard. I had to think about what my ultimate goal for this blog is. I came to the conclusion that my goal is to learn myself, while also contributing my readers’ learning. In this sense, I think full transparency is best. I should talk about stocks that meet my quality standard, as well as stocks that do not.

I am by no means trying to identify “short” candidates. I am only saying there are things about the business I do not understand. And remember there is a difference between a high quality company and a high quality investment. A low quality company can make a great investment if bought at the right price.

I think being able to reject stocks is a prerequisite to becoming a good investor. The reasons for rejection deserve close scrutiny. I think I can enhance everyone’s learning by subjecting my reasons for rejection to close scrutiny.

One of my original thoughts was to use this blog as a platform so that company executives would be more willing to talk to me. This is what made the decision hard. By showing my willingness to publish both positive and negative views, executives may deny access. Ultimately, obtaining corporate access is not a primary goal for the blog, and this is why I have chosen the path I did. Besides, good companies should have nothing to hide and be willing to tell their story to anyone who will listen. So here’s to everyone learning!

With that preamble, the subject of this blog post is DMD Digital Connections (TSXV: DMG-H). Here are the things that cause me to question the quality of DMD:

  • A weird debt structure
  • High regulatory risk
  • Weak publishing partners
  • Listing on the NEX exchange
  • Aggressive stock option grant in 2016


DMD owns a database containing the names, emails, specialties, and addresses of physicians, nurse practitioners and physician assistants. DMD is a database licensee authorized by the American Medical Association to maintain AMA physician professional data for mailing purposes. It is important to note that the AMA does not provide email data on physicians. DMD accesses email addresses through partnering with online content publishers that focus on the medical industry. When someone signs up for an email newsletter on a partner site, DMD cross references the name with its list of names from the AMA. If there is a match, the email is “authenticated” and DMD is now able to provide its customers (pharma companies) with a verified email for a physician.

The company has added to its email list offering with an offering known as Audience Identity Management. This tool allows pharma companies to figure out who is visiting what pages on their website even if the user is not logged in. The tool also helps to combat ad fraud. It allows medical publishers to prove to advertisers who their audience is (and that it contains their target; physicians).

Audience identity management works as follows: 1) when a physician or nurse signs up at a publishing partner, there is a tag embedded in their browser, 2) the web page that wishes to track who is visiting has a reader embedded in the Javascript, 3) when the reader on the website encounters a tag, it communicates with DMD’s server to provide more information on who the visitor is (ie. name, specialty, address, email, they can also get a practitioner number which can be joined with data bought from IMS to figure out the prescribing history of the doctor).

The audience identity management tool (AIM) has been a huge success for DMD and I estimate most of the company’s growth has been attributable to this product over the past two years (DMD has gone form $21M of revenue in 2014 to $41M in 2016).

The AIM tool has been such a large success for DMD because there is no other tool like it on the market right now. The AMA makes public who the other Database licensees are: Medical Marketing Service, IQVIA, Redi-Mail Direct Marketing, J Knipper, Veeva Systems, and QPharma:

  • Knipper and QPharma are focusing their business on samples and making sure drug companies are in compliance with sending out free samples by authenticating doctors receiving samples against the AMA list.
  • For IQVIA and Veeva, the AMA list is part of a much broader offering; the goal of this offering is to identify who future Key Opinion Leaders will be with advanced segmentation. They do not appear to have offerings that allow a website to identify a user without them logging in. But it is worth noting that both companies are very large relative to DMD and have much greater resources.
  • Medical Marketing Service has an email list; MMS also has a tool for publishers to identify their audience, but my impression is that it requires a user to login (unlike DMD which does not require login).
  • Redi-mail has an audience tracking tool that can work without login, but it only works when the user has your app installed on their phone or tablet (as opposed to DMD which does not require an app download as it works with tags embedded in the browser).


As of the most recent financial statements (Q2 ended June 30, 2017), Cegedim had debt on its balance sheet of $6.7M. On the asset side, DMD has $0.3M of cash and $8.8M of restricted the cash. The debt has a weird covenant which means that DMD cannot pay out any of its cash it is generating until the debt is fully paid off. DMD recently renegotiated the debt so that it will not be fully repaid until October 2021. This means that shareholders will not be able to gain from any dividend or share buybacks until at least 2021.

Weird, but it gets weirder. Under the previous agreement, DMD had to pay the higher of US$125,000 per month or 1/12 of 35% of the last annual audited EBITDA. In 2016, DMD earned an operating profit of C$7.3 million and amortization was C$1.1 million so that EBITDA was C$8.4 million. The average USD/CAD fx rate during the year was 1.3249 so the EBITDA in US$ was US$6.3 million (C$8.4M / 1.3249). So based on the agreement DMD should have paid the higher of US$125,000 per month or US$184,000. The US$184,000 is equal to the annual EBITDA of US$6.3 million divide by 12. However, DMD did not pay the higher amount; they paid the lower amount. DMD paid C$1.987 million of debt repayments during the year which is equal to US$1.5 million (or US$125,000 per month). I’m willing to admit the debt covenants are complicated and I may be misunderstanding them – but any investor in DMD should be asking management about this.

Regulatory risk

Given the business model, there is a high amount of regulatory risk involved. Privacy laws are subject to change. DMD acknowledges this risk in its filings: “There are a large number of legislative proposals pending before domestic and foreign governments concerning privacy issues related to Internet-based business. It is not possible to predict whether or when such legislation may be adopted.”

The Digital Advertising Alliance is attempting to set standards for how people are tracked online. One of the key components is that data is de-identified. This is not what DMD is doing as a specific part of their offering is about providing personal contact information.

List of publishing Partners

The list below is all the websites I could find that specifically mention DMD in their privacy policy. Once a physician signs up to receive emails from one of these websites, they are giving permission for DMD to track them using tags and to sell their email address onto Pharma companies.

I’d note that none of the websites appear to be the most prestigious in their field. There is nothing from Annals of Internal Medicine, or Nature, or Mayo Clinic Proceedings, or Journal of Pediatrics or Journal of Clinical Investigation – you get the point… I would say the list is mostly second or third-rate publishers trying to make a buck.

GlobalRPh.com, Aesthetics CME (continuing medical association), Fidelis partners – career search, PAH.tv (pulmonary arterial hypertension), Endocrine society, Diabetes in control, Oncology tomorrow, HMP Global, Delta Healthcare providers, Statnews.com, Gomerblog.com, The Oncologist, Medoptions.com  Clinical Oncology – www.clinicaloncology.com,  Healthline, Broadcastmed, Global Neurology Academy, Stem Cells Translational Medicine, The Doctor’s channel, Healthjobsnationwide.com, Global Women’s health academy, Reachmd.com, medlexicon.com, ehealth-news.com.

Another point of note is that Wolters Kluwer is a competitor in that they offer data on physicians. Wolters Kluwer owns Lippincott Williams & Wilkins (LWW) which publishes several medical journals. These journals are higher quality than any publisher DMD partners with.

NEX Exchange:

DMD is a bit strange as the company trades on the NEX exchange. The NEX exchange is a rung below the TSX venture exchange, meaning most companies on it are dormant or not active. DMD is on the NEX exchange because the company stopped filing financial statements for a period of time. The company was late to file its 2011 financial statement because of a dispute with its auditor over fees. While this is obviously a red flag, I am willing to give them the benefit of the doubt as they were able to drastically reduce audit fees when they switched from their old auditor (KPMG) to their new auditor (Guimond Lavalee). See Figure 1.

The NEX exchange has lower listing maintenance fees than the venture which is likely why DMD has stayed listed on the NEX. DMD easily meets requirements around net tangible assets and operating income to list on the Venture exchange if it chose to.

In terms of financial reporting and incentive compensation, it is important to note that there is no difference between being listed on the NEX versus the Venture. Financial reporting and stock based compensation is governed by securities laws and not the exchanges. The securities laws do not differentiate between NEX-listed and venture-listed issuers. Both sets of issuers require need audited annual statements, interim statements and MD&A. An Annual Information Form is optional for both sets of issuers.

Stock Options:

DMD made a very large option grant in 2016. The company has 199 million shares outstanding and made a grant of 16 million shares. This represents 8% of shares outstanding. Note that the maximum annual grant of stock options in a 12-month period allowed by securities laws is 10%; DMD is getting very close to this level. It is important to note that DMD has not always been a serial issuer of options. The grant in 2016 was the first large grant since 2009. At this point, it is unknown whether or not grants will start recurring on an annual basis. Of the 16M shares, 8.7M shares went to the Board, CEO, CFO and COO.

The job boards on the internet disclose that there has been a large executive management shake-up at the company. It is possible that the remainder of the options may have gone to some of the new executives.

The amount of options granted is concerning. So is the strike price. On the date the options were granted, DMD shares were trading at $0.20. One would think the strike price should be at least $0.20. But NO! DMD decided to issue options to its executives with a strike price of $0.15. This practice is legal; but just barely. The maximum discount you can put on option grants for shares under the price of $0.50 is 25%. DMD issued its options at precisely a 25% discount. So basically management will make money on these options as long as the share price does not decline by MORE than 25%.

It is important to note that related parties own 25.4% of shares outstanding at DMD. The shares have not been earned through options grants over time, they have had an interest since the beginning.

The Company’s website: http://www.dmdconnects.com/

Author Ownership: No TSXV: DMG-H

Read Disclaimer:

This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

Qualitysmallcaps.com is not engaged in an investor relations agreement with DMD Digital Health Connections Group nor has it received any compensation from DMD Digital Health Connections Group for the preparation or distribution of this article.

The author of this article has acquired and may trade shares of DMD Digital Health Connections Group through open market transactions and for investment purposes only.

Searching for yield with Becker Milk (TSX: BEK/B)

The Becker Milk Company (TSX: BEK/B) has lots of things to like about it:

  1. For starters, it is a simple company. Becker owns real estate. Becker owns and manages 57 properties with a total of 73 retail store units and two residential units. Of the 73 retail units, 46 are leased to Mac’s (a subsidiary of Alimentation Couche Tard; TSX:ATD/B), 20 are leased to other tenants and 7 are vacant. One property is in metro Toronto and the rest are in Southern Ontario.
  2. Another thing to like about Becker is the balance sheet. Becker has net cash on its balance sheet of $4.5 million as of Oct 31, 2017. The company also noted it sold two properties subsequent to Oct 31 which would increase its net cash on balance sheet to approximately $5.5 million. It is extremely rare for a real estate company to not be leveraged to the hilt. Becker is impressive in this regard.
  3. Becker is small and likely underfollowed as a result. The market capitalization of Becker is $28 million. The company only has five employees.
  4. Management pays itself a reasonable amount. While it is arguable whether or not Becker has enough scale to justify the cost of a public company, the CEO pays himself a total package of about $225,000, there is a vice chairman who is paid $115,000, and the CFO is paid $48,000.
  5. In late-2013, there was an offer for the company at $21.00 per share by Firm Capital. The current share price is $15.70. The current shares are trading below what a third party willing to buy the whole company was willing to buy them for. It’s important to note it is not an exact comparison as Becker has sold 10 properties since 2013.

As I dug into the company, there were a couple of things that stood out:

  1. Environmental liabilities. Becker has 13 properties with a gas bar on them. Gas stations cause problems because of contaminants that can find their way into the soil. There are two major repercussions if a site is contaminated: 1) it scares away lenders and makes it more difficult to find financing, and 2) limits ability of owner to change use/zoning until site is remediated.
  2. 85% of Becker’s revenue comes from Mac’s which poses significant concentration risk.
  3. There is a dual-class share structure in which the shares traded on the TSX are non-voting. A takeover offer can be made for the voting shares without making an offer to the non-voting shares (ie. there is no coattail provision).

Valuation. Becker’s trades at 0.86x book value and a dividend yield of 5.1%. While these measures suggest Becker’s may be on the cheap side, it by no means an eye-popping bargain.

Environmental Liabilities

In terms of environmental liabilities, the vast majority of Becker’s obligations are in the past. I do not expect there to be any major future liabilities related to environment remediation. To explain, a bit of a history lesson is required.

Becker sold its dairy and convenience store operations to Silcorp in November of 1996. Silcorp was subsequently acquired by Alimentation Couche-Tard (TSC: ADT/B), so that the convenience store operations now reside within Couche-Tard. While Becker sold the convenience store operations and dairy, the company retained its real estate. The real estate is now the primary asset of Becker.

As part of the sale to Silcorp, Becker agreed to remediate certain sites which included gas stations in return for indemnification from future environmental liabilities. Between 1997 and 2008, Becker spent between $10 and $15 million on environmental remediation. In the late 90s/early 2000s, Mac’s and Becker were names co-defendants in a series of lawsuits related to environmental liabilities with total claims of $10.5 million. The indemnification held up, and Becker did not pay any material amounts related to these lawsuits.

More recently, Becker re-initiated a strategic review in Q2/FY14. As part of the review, Becker completed an initial environmental review on all of its properties. A more in depth review was completed on about half of the properties where it was deemed warranted. At the end of the review, Becker reduced the fair value of its property portfolio by $850,000 for additional remediation obligations (or an undiscounted value of ~$1.5 million). While disappointing, this future obligation is much less than the $10-$15 million Becker spent on remediation between 1997 and 2008.

One more point on environmental remediation. Another lawsuit was brought against Becker/Mac’s in 2016 for $1.7 million. Becker believes the lawsuit is unwarranted and the damage claimed is actually from another property and not the one owned by Becker and operated by Mac’s. Becker has filed their defense and the plaintiff has yet to take any further action.

Given the amount Becker has already paid related to environmental remediation, and that Becker has already come through a series of lawsuits unscathed, it increases my confidence that Becker will be able to handle any future issues with regard to environmental remediation without any major liabilities.

Customer Concentration

As noted above, Mac’s is a major customer of Becker’s. In their year ended April 30, 2017, Couche-Tard made up 85% of Becker’s revenue.

While this is a large amount in any case, it is even more significant when there is a history of tumultuous relations. As mentioned in the above section on Environment, Mac’s and Becker’s were named as co-defendants in a series of lawsuits. As part of this ordeal, Mac’s filed a claim against Becker’s and Becker’s filed a counterclaim.

Between 2005 and 2008, Mac’s announced its intention to renew leases, but refused to enter into negotiations with Becker’s on rent increases. The whole situation was messy and ultimately had to be resolved in mediation. And even after agreements were agreed to in principle, there was a lag in implementation, and Becker had to threaten further legal action.

Ultimately, there were new leases agreements signed in 2008. But this did not happen without Becker’s and Mac’s going through mediation. The agreement in 2008 covered 58 of 64 leases and saw annual rents paid to Becker increase by a total of 8%  in 2009 (relative to 2008). This can be thought of as making up for an annual increase of roughly 2% per annum between 2005 and 2008.

Post 2008, relations ran smoothly for a few years, but based on Becker disclosures, Mac’s started being difficult to negotiate with again in 2012. Since 2012, Mac’s has generally agreed to renew/extend leases. However, Mac’s and Becker have not been able to negotiate a new rental price, and as a result Mac’s has continued to pay what it was paying under the previous agreements. At the end of April 2017, it got to the point where Mac’s has renewed a total of 40 leases since 2012, but rental amounts have yet to be negotiated (for context, Mac’s leases a total of 56 sites from Becker’s; so 40 of the 56 sites do not have a current lease agreement as it relates to rental price).

So in summary, there has been a history of poor relations between Becker’s and Mac’s, even though Mac’s is Becker’s major customer. Currently, 40 of Mac’s 56 leases with Becker’s have expired and a new price has not been set. The amount of expired leases has been increasing each year since 2012.

This could ultimately be positive, as it means Becker’s has been under-earning and should see an increase to its rents once the leases are re-negotiated. In any event, Mac’s appears to be the one with the bargaining power at the negotiation table.

Share Structure

It is important to be aware that Becker’s share structure is made up of 540,750 common shares and 1,267,710 Class B Non-Voting shares. The class B shares are the shares traded on the Toronto Stock Exchange. The common shares are the voting shares and are 100% controlled by the founders and their families (Bazos, Panos, Pottow).

Class B shares do not have the right to participate in a takeover bid made for the common shares (ie. there is no coattail provision). Theoretically, this means that an acquirer could make an offer for the common shares and not have to make an offer to the Class B shares. In my opinion, there is not a whole lot of strategic value to controlling the company’s assets. So such a bid for only the common shares would be unlikely. Any acquirer would likely want the assets for the cash flow they generate. In this sense, Class B shareholders are protected because they participate in dividends equally with the common shares.


Becker’s trades at 0.86x book value and has a dividend yield of 5.1%.

Book Value

To determine if book value is  valid measure, we have to consider the assets on the balance sheet. By far, Becker’s largest asset is its property making up about $32 million of its total $37 million in assets.

Since adopting IFRS accounting in 2012, Becker has included the change in fair values of its real estate portfolio in its income statement each year. This has the effect of including the real estate portfolio at “fair value” on Becker’s balance sheet. When it comes to valuing commercial real estate, the most important variable is known as the capitalization rate (“Cap Rate”).  Fair value is calculated as net operating income / cap rate. So if net operating income is $50,000 and we use a 5% cap rate, then fair value would be $1,000,000. Important to note that net operating income is rents less operating expenses such as property taxes, management fees etc. Operating expenses in the calculation of net operating income do not include interest expense or depreciation and amortization.

The cap rate Becker has used to calculate the fair value of properties on its balance sheet is currently 7.9%. At April 30 2017, Becker valued its properties at $31.3 million. Based on the 7.9% cap rate, this means they should generate operating income of $2.46 million. When we look at the income statement (see below), we see property revenue of $3.66 million, property operating expenses of $0.54 million, and admin expenses of $1.32 million.$3.66 million less $0.54 million less $1.32 million is equal to $1.80 million. I think the reason for the difference is that not all of Becker’s admin expenses should be included in the calculation of net operating expenses (for calculation of operating income). I think it is reasonable to exclude audit fees as well as wages paid to the three named executives and three directors. In total, this amount adds up to nearly $575,000. If we add this to the $1.8 million above, we get much closer to operating income backed out from the cap rate of $2.46 million.

The history of the capitalization rates Becker’s has used can be seen in the graph below. At first glance, the 7.9% cap rate seems somewhat high, which would mean that perhaps the ‘fair value’ is actually understated on Becker’s balance sheet.

However, upon further examination, the cap rate appears to be appropriate. We can check the cap rate for sensibility by looking at cap rates published by the major commercial brokerage firms. For Q3/17, Colliers noted that the cap rate for a strip mall in Ottawa Ontario is between 6.25% and 7.00%. Cushman Wakefield estimated a non-anchored strip plaza in London Ontario traded between a cap rate of 5.75% and 7.00% in Q3/17. Becker does not disclose exactly where its properties are, other than saying that only 1 is in metro Toronto and the rest are in Southern Ontario. I think it is likely that a significant number of Becker’s properties would be in locations more rural than London or Ottawa, which would make a higher cap rate reasonable.

We can also test the cap rate assumption for reasonableness by examining recent dispositions from Becker’s portfolio. Over the past 5 years, every single property that Becker has sold has been at a loss. This means that the proceeds Becker has received have been less than the amount recorded on the balance sheet. This would suggest that the capitalization rate being used may actually be too low, rather than too high.

During the first six months of FY18, Becker has sold $1.8 million of properties. This is more than the total of the past 5 years displayed in the table below. Becker also disclosed that there was a positive adjustment to fair value of its properties during the first six months of FY17. The reason for the positive adjustment is that properties were “transferred to held-for-sale at values higher than their previously appraised values.” This suggests that the properties Becker has sold more recently have been at higher values than recorded on its balance sheet.

I did all of this work with the intention of being able to come to the conclusion that the amounts for property recorded on Becker’s balance sheet are either too high or too low. However, there does not appear to be any clear evidence this is the case. I think the cap rate chosen by management (7.9%) and the associated fair value of properties is reasonable.

Dividend Yield

In terms of a dividend, Becker currently pays C$0.80 per share and has done so for the past 4 years. This represents a fairly attractive yield of 5% on the current share price of 5%. However, it is important to note that Becker’s dividend is being “topped” up by asset sales. Over the past 4 years, total free cash flow (before asset sales) has been about $700,000 less than dividends paid. This is a cumulative ~$0.40 per cents or $0.10 per annum, implying an “organic” dividend of $0.70 per annum. On an organic basis, the dividend yield is still fairly attractive at 4.3%.

Author Ownership: No TSX: BEK/B

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This article is for informational purposes only. This article is based on the author’s independent analysis and judgment and does not guarantee the information’s accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.

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Vigil Health (TSXV: VGL): A Quality Microcap

Vigil Health is the subject of my first post. Vigil trades on the TSX-Venture exchange and is relatively illiquid given the market capitalization is C$15 million. I reiterate the following post is not meant to be investment advice, but rather some thoughts around a quality small/micro cap company. I have provided some work on valuation for my own reference.


  • Vigil’s core end-market (senior housing) will likely be under continued pressure to cut costs over the coming years due to there being a single dominant payer (Medicaid). Medicaid itself will be under pressure to reduce costs to help stem the massive US federal deficit.
  • Vigil is in a unique position to help the industry save money by offering a lower-cost nurse call and wander management (ie. memory care) system. Vigil is able to offer a lower cost solution because:
    • Vigil offers a bundled nurse call and memory care system. Other providers have nurse call and need to partner to provide memory care which implies two layers of margin and a higher cost to the customer.
    • Vigil focuses on the senior housing market. Many providers have a focus on the hospital market which requires higher end systems with more integration capabilities. As a result, these competitor systems have a higher cost.
    • Vigil sells through its direct sales force to large corporate customers. Many providers sell through distribution, which again implies another layer of margin and higher cost to the customer.
    • Vigil is a small company with limited overhead. A Government of Canada website discloses there is only 17 employees. Linkedin says 27 employees. Either way, it is small!
  • Recent share price weakness has been due to a slowdown in revenue growth that first happened when Vigil reported Q1/FY18 results in August 2017. This revenue slowdown is expected to be temporary because:
    • Both bookings and backlog are currently strong which signal future revenue growth.
    • Vigil operates in a very large market and there is room for deeper penetration.
    • There is lots of opportunity for Vigil to broaden its product offering and expand into adjacencies.
  • Chairman Greg Peet owns 28% of shares outstanding. Peet has a strong track record having sold A.L.I. Technologies to Mckesson and Contigo Systems to Vecima Networks.
  • Strong balance sheet with $1.9 million of cash and no debt. Vigil has been cash generative in each of the past 5 years.
  • Valuation is reasonable at about 15x FY17 earnings.

What they do (ie. the basics)?

Vigil focuses on software solutions for the North American senior housing market. The company has a system used for patient monitoring that enables emergency and nurse calls. Its marquee offering is used for patients with memory impairment or dementia. These patients are unable to use a traditional method of pushing a button or pulling a string to call a nurse. Vigil provides software and associated sensors to monitor patients in a non-invasive manner and alert nurses when their patterns of behavior or movement are not normal.


It is important to begin any discussion about a company with thoughts about the industry. As Warren Buffet famously noted, “I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Vigil serves the senior housing market. The two key drivers of the senior housing market will be: 1) number of seniors, and 2) price paid per a senior.

Number of Seniors: The aging of the boomers will contribute a tailwind to the industry for many years to come. This can be seen in two charts from the US Census Bureau. The first chart shows the growth rate of people aged 65+ versus the growth rate of the total population. The population aged 65+ is projected to grow at a much faster rate than the total population between 2010 and 2030. The second chart shows the history and projected future of the total population aged 85+. The number of people over 85 in the USA is projected to grow from roughly 5.7M in 2010 to 9.0M in 2030 (annual growth rate of 2.3%).

Price paid per Senior: From a pricing perspective, the overall health of the industry is more uncertain. This is because of the very high costs associated with Nursing homes and the dominant role that Medicaid plays in paying for these costs. Genworth (an insurer) notes that the median price for a private room in a long-term care facility now totals $90,000 on an annual basis. The Kaiser Family Foundation notes that 64% of nursing home residents receive coverage from Medicaid. This is an astronomical number. In 2015, Medicaid spent a total of $54 bn on nursing facilities. Nursing facilities are part of a broader bucket of Medicaid spending called Long-Term Services and Supports (LTSS) which includes Home and Community Base Services (HCBS). In 2015, a total of $158 bn was spent by Medicaid on LTSS.

When looking at the total LTSS Medicaid spend bucket, an interesting divergence has occurred over the past 15 years. While total spending has increased, it has been almost entirely driven by HCBS. The institutional bucket of spend (which includes nursing homes) has shown very little dollar growth (see chart below). My interpretation is that there has been pressure to reduce spend in high-cost facilities or environments (ie. nursing homes) and transfer that spend to lower cost environments (ie. home-based care).

The providers of senior housing have adapted to the pressure on nursing home spending by altering the mix of units being constructed. There has been a growing number of independent living units (ILU) and assisted living units (ALU), while the number of nursing care beds (NCB) has been relatively flat. There has also been growth in Continuing Care Retirement Communities which are aimed at providing the full continuum of care all within a single community. Note that the data in the chart below is from a joint publication by Ziegler (a specialty investment bank) and Leading Age of the top 150 non-profit providers of senior housing. It is likely the trend would be even more pronounced if for-profit providers were included.

In summary, while senior housing is expected to benefit from the continued aging of the population, there will likely be continuing pressure to cut costs given the dynamic of having a single dominant payer (Medicaid). Medicaid can use its scale to pressure a fragmented supply-base into pricing concessions. The pressure will likely be continuous as Medicaid itself will also fall under pressure to cut costs to help cope with ever-mounting budget deficits in the United States (note that Medicaid is the third largest domestic program in the federal budget after Social Security and Medicare).

This dynamic has the potential to be positive for technology providers such as Vigil. The three largest costs for a senior housing provider are labor, food, and utilities. Technology has the potential to increase productivity and bring down labor costs over time.


Vigil has three core products: a wired nurse call system, a wireless call system, and a memory care system. The core function of all three products is the same; to allow patients to communicate with their caregivers in case of discomfort, pain or emergency.  From a broad perspective, Vigil competes with all Nurse Call providers.

However, one way in which Vigil differentiates itself versus other nurse call competitors is its singular focus on senior housing. Many of its other competitors have a “hospital first” mentality. According to Centers for Medicare and Medicaid Services (CMS.gov), total healthcare spending in the United States was $3.3 trillion in 2016 (18% of United States GDP!). Of this amount, 32% or $1.1 trillion of spending was attributable to hospital care. Only 5% or $163 billion was attributed to Nursing Care Facilities and Continuing Care Retirement communities.  The much larger spending in the hospital setting naturally attracts more and larger competitors, while senior housing is neglected.

The neglect of the senior housing sub-segment can be seen in the actions of some of the large Nurse Call competitors. At a 2014 conference held by Piper Jaffray, Hill-Rom disclosed that the economics in the States for long-term care, nursing home facilities have not been terribly attractive, and as a result they do not have a lot of business in the nursing home end market. 3M seems to concur with this statement as demonstrated by its abrupt exit of its Homefree or its resident monitoring product line in 2013. It’s also worth noting that only two of the six top nurse call providers had a presence at the Argentum conference which is one of the largest conferences for companies that own operate and support professionally managed senior living communities. Tektone and Ascom had a presence, while Elpas (Tyco), Rauland (Ametek), Jeron and West-Com did not have any presence (indicating they are not actively targeting senior living).

Of the two competitors with a presence at Argentum, it is worth noting: 1) Tektone does not actually provide wander management solutions for seniors with dementia itself; it partners with Accutech, and 2) Ascom is a large company with a focus both in Europe and hospitals. Given the relative size, Vigil can provide much better service (no bureaucracy) than Ascom while providing a solution that is tailored to senior housing rather than hospitals. The complexity of care at hospitals is much higher and Ascom has spent a lot of resources (that it looks to get paid for) on integrations which are not necessary at a nursing home.

I believe that Vigil has carved out a unique niche for itself by focusing on the senior housing market. Given its small size and limited overhead, Vigil can effectively compete by offering senior housing providers a lower cost versus its larger competitors focused on serving more complex needs of a hospital. Cost is very important to providers of senior housing given the industry-wide pressure to reduce costs as a result of there being a dominant payer (Medicaid). Medicaid is able to use its scale and ability to benchmark against best-in-class providers to reduce payments to senior housing providers meaning that the cost of any technology solution is a decisive factor when deciding which technology vendor to select. Vigil can also offer a better cost than competitors who have to find partners to be able to provide nurse call and wander management. Vigil only has a single layer of margin whereas competitors who partner must split the profit between two or more parties.

Growth Opportunity

New Customers: Based on Vigil’s ongoing disclosure, it is difficult to assess new customer acquisition. Vigil groups project revenue from both new and existing customers together in the same bucket. However, we can gauge Vigil’s current level of penetration given its disclosure that its installed base consists of over 500 projects representing more than 38,000 beds.

The key question is what to use as an addressable market. According to Ziegler (a senior housing focused investment bank), there are a total of 1,060 Memory Care communities in the United States with a total of 51,000 beds. If we assumed that Vigil’s addressable market only consisted of Memory Care communities, this would imply Vigil has nearly fully penetrated the market in the United States.

However, this would be a mistake as Vigil does not just serve memory care. Vigil provides solutions across the care continuum so as to have an offering for each level of care in a Continuing Care Retirement Community. In total, when looking at independent living, assisted living, and nursing homes, there are roughly 3.2 million units across the united states (Source: Ziegler). This would imply a much lower penetration of 1.2%.

My thinking is that neither one of these numbers is right. Vigil’s core opportunity really lies in communities that have both memory care and other forms of senior housing (ie. combination of independent, assisted and nursing home). Most of Vigil’s sales come through its direct sales force. Due to its limited number of employees, it only makes sense from a resource and cost perspective for Vigil to target large providers of senior housing with a mix of housing options across the care continuum.

Existing Customer Penetration: Vigil also has an opportunity to increase spending from existing customers. As a whole, software and IT is relatively under-developed within senior housing. There are two points that support this: 1) A survey from Zeigler found that only 21% of organizations had a Chief Information/Technology Officer position, and 2) Only 20% of residential care communities use electronic health records (source: Getting to 2025: A Senior Living Roadmap; Argentum).

Vigil has demonstrated an ability to adapt its offering to appeal to adjacent markets. Vigil started off specializing in only Memory Care for skilled nursing facilities. Over time, Vigil has added additional systems so that it can offer a Nurse Call product. The company has also added systems to expand into assisted living and independent living facilities (with lower levels of care relative to a nursing home).

To date, Vigil has focused all of its software on the interaction between the resident and the onsite nurse or caregiver. There are many other interactions at a senior housing facility where technology has applications:

  • Interaction between caregivers on the ‘front line’ and the attending or primary physician doctor. This would likely entail automation of relevant information into the residents’ Electronic Health Record. Could also include things like Electronic Medication Administration Records (eMAR) and electronic treatment authorization requests (eTAR).
  • Interaction between nurses and administrators. This could entail a real-time locating service to monitor the movements of nurses and time spent with each patient. This would allow administrators to monitor the productivity and utilization of nurses (to help with scheduling) as well as have applications with billing (ie. patients who require the most time from a nurse are charged more).
  • Interaction between residents and their families. This could include monitoring of health, or activity with automated communication/notification sent to family on an opt-in basis. It could also monitor what are known as activities for daily living, such as eating, dressing, bathing (by putting sensors on things like fridge, closet, shower) and alert family members when an increased level of care may be needed (ie. a move from assisted living to nursing home).

Balance Sheet

A strong balance sheet is essential for very small companies like Vigil. Small companies have a much more difficult time accessing capital markets than large companies. Some hedge funds will search for small/micro caps in search of funding and go short the stock so that they can buy it back on an upcoming share issuance.

Vigil’s balance sheet is solid with a cash balance of $1.9 million and no debt.

It is worth noting that Vigil has an accumulated deficit of $12.4 million on its balance sheet. This means that company has lost more money than it has made over its history. While this can be a troublesome sign, it is worth noting that Vigil has been profitable in each of the past five years (starting in FY13).

I am not worried about the accumulated deficit because Vigil is a software company. This means its capital expenditures are very low. A large reason for the accumulated deficit are R&D costs that have been expensed as incurred. The company recognizes costs related to R&D before it is able to sell the software to customers and receive revenue. Another reason for the deficit is that Vigil was too aggressive on sales and marketing expense when Vigil first IPO’d (between FY03 and FY06). The company scaled back its sales and marketing in FY07 and concentrated on specific geographies where it had success rather than full nationwide coverage.

Return on Capital

Vigil is currently reinvesting most of its money into R&D and sales and marketing. When the company gets to a larger scale, it will earn a very high return on capital because of the lack of fixed assets in the business. Vigil has tangible assets of $2.0 million which are mostly comprised of accounts receivable, inventories, and contracts in progress. There is about $1.2 million of deferred revenue (cash received from customers in advance of billing) and $0.5 million of A/P so invested capital is very low at only about $0.3 million.

This begs the obvious question; why would new competitors not enter and drive down returns on capital given the invested capital in the business is so low? The answer is that Vigil has accumulated significant expense related to R&D and developing its sales force and brand. Over the past 10 years, Vigil has spent $4M on R&D and $8M on sales and marketing.

Board and Management

Management’s interests appear to be aligned with shareholders given the chairman owns a large chunk of the company and the CEO draws a modest base salary.

The chairman of the board, Greg Peet, is an experienced entrepreneur. Peet made his name for himself by selling A.L.I. Technologies to Mckesson for $526 million. A.L.I. was a medical imaging company tat Peet grew from 14 employees in 1993 to over US$100 million in revenue per annum. Peet was also a part of Contigo Systems which was sold to Vecima networks. There is a quote from a Financial Post article about Peet that stands out, “Early-stage ventures have to be too early to a market,” he says.  “If you build a product when every other company is doing it, bigger companies will have more resources and you’ll be too late.” One has to wonder if Vigil is taking a page from Peet’s playbook by focusing on the Senior Care market while the other major nurse call providers focus on the larger hospital market. Peet’s interests are aligned with shareholders as he owns 29% of Vigil’s shares outstanding.

Troy Griffiths has been the CEO of Vigil since March 2005. He is an accountant by trade. Troy Griffiths owns 611,000 shares. He draws a relatively modest base salary of $150,000 and his total compensation package was $235,000 in the year ended March 31, 2017.

Vigil issued 394,000 options at it AGM in 2017. This represents approx. 2% of the share base. While this seems a bit high, Vigil’s market capitalization is only $12M which necessitates a rather large option grant to pay its executives fairly. It is worth noting that the strike price on the options were the same price as the closing price on the day they were granted. This is a sign of good governance as TSX Venture exchange rules allow corporate issuers to grant options with a strike price up to 25% below the closing price on the day of the grant.

Recent Share Price Movement

Vigil has most recently traded at $0.85 per share which is down significantly from its Aug 15, 2017 peak of $1.20. Vigil operates on a March 31st year-end. The company reported its first quarter of FY18 on the same day that Vigil’s share price peaked (implying the market was unhappy with the results).

What was so bad about the quarter? Revenue in the quarter was $1.49 million versus $1.66 million in Q1/FY17, representing a decline of 10%. Vigil increased its gross margin in Q1/FY18 (55% vs 52% in prior year), but this was more than offset by increased payroll related to administration, R&D, and sales and marketing. Operating income was down 56% year over year as a result of higher expenses on a lower revenue basis.

While these headline numbers seem weak, there are a few things worth point out. The first being that FY17 was a very strong year for Vigil, meaning the company was facing a tough comparison. Revenue in FY17 was up 40% y/y, while revenue in Q1 of FY17 was up 30% y/y. A second point is that while revenue was down, bookings (an indicator of future revenue) were up 38% y/y to $1.85 million, from $1.34 million.

The last point is that Vigil reported Q2/FY8 results on Nov 14, 2017. Vigil managed to increase revenue 2% y/y in the quarter to $1.61 million. It is worth noting that Q2/FY17 revenue for Vigil was up 70%, so again the company was facing a tough comp. Bookings were up 37% to $1.93 million in Q2/FY18. Backlog now sits at $3.23M due to the strong bookings, and is up significantly from the low point of $2.44 million which was reported with the Q4/FY17 results.

A key point in all of this is that quarterly results can be very volatile for Vigil. The root cause is that Vigil’s revenue is made up of a split of large projects and service/maintenance/replacement billings. The large projects are not booked into revenue until the installation is complete and the customer signs off that performance obligations have been met. This creates a lumpy stream of revenue that is rather volatile for Vigil (see chart below).

Vigil’s revenue from maintenance/service/repair sales is much more stable and has been growing each year. When Vigil sells a system, it includes one-year of warranty and support (24 hr emergency client support by telephone). After the first year, facilities can purchase support and maintenance for somewhere in the range of 10% to 20% of the original price. The benefit of purchasing ongoing maintenance is that the facility gets access to the support center, software upgrades, and revisions to training and technical documentation.

The last chart puts the recent top-line weakness into context. The red-line is revenue on a trailing twelve month basis (TTM). While the trend has flattened out, this does not appear unusual relative to Vigil’s historical performance. I do not think the flat year over year revenue growth is a sign of impairment to Vigil’s ability to successfully compete in the market. Vigil’s actions appear to support this statement. Vigil is a very small company. A government of Canada website discloses that Vigil only has 17 employees. For a company this small, hiring new employees is a crucial decision and signals internal confidence in the future of the confidence. Vigil has been hiring recently as demonstrated by its higher expenses. The company also recently had a job opening for a business development associate; again signaling future confidence in the business.


Vigil currently has 17.7 million shares outstanding and recently traded at a share price of $0.85 for a market capitalization of $15 million. Vigil’s IFRS net income in FY17 was $2.1 million which is a very low P/E ratio of 7x. However, $1.1 million of net income was related to an income tax recovery. If we exclude this amount, the P/E ratio would be ~15x, which is still cheap for a company with VGL’s growth potential (and in the context of the current stock price environment).

Given that Vigil is early in its development, it is worth estimating what VGL could potentially trade at in the future.

I think in order to invest in Vigil, you must believe that the revenue growth slowdown is temporary. I think it is reasonable to assume Vigil can grow revenue at an average of 10% over the next 5 years. This implies Vigil can grow its revenue from $6.8 million in FY17 to $10.9 million five years out. Over the past 3, 5 and 7 year periods, Vigil has grown revenue at 10%, 15% and 8%, respectively.

If we add a few other estimates to our revenue estimate, we can forecast an EPS number five years out:

  • Gross margin of 50% versus FY17 of 51% and five year historical average of 50%
  • G&A as % of sales of 11% versus FY17 level of 15% and five year historical average of 19%. I am implicitly assuming this is mostly comprised of fixed costs (ie. CEO’s salary, audit fees, etc.) that will stay fixed as the company grows its top-line.
  • R&D as % of sales of 8% versus FY17 level of 7% and five year historical average of 8.5%.
  • Sales and marketing as % of sales of 15% versus FY17 level of 15% and five year historical average of 19%.
  • Tax rate of 26% (Vigil’s combined federal and provincial statutory rate). This is relative to tax recovery in FY17 and no taxes paid over the past five years.
  • Share count increases at a rate of 2% a year to account for stock-based compensation.

The net result of these assumptions is an EPS forecast of $0.07. It is worth noting that the assumption that Vigil has to start paying taxes is a key reason for why this $0.07 EPS forecast is not higher. A 15x multiple on $0.07 would imply a share price of $1.01. While a 20x multiple would imply a share price of $1.34.

If we are more optimistic and assume 15% top-line growth, implied share price at a 15x multiple is $1.44 and at a 20x multiple implied share price is $1.92.

If we are more pessimistic and assume top-line growth of 5%, implied share price at a 15x multiple is $0.64 and $0.86 at a 20x multiple.

Note that these share price forecasts do not take into account the time value of money and are simply meant to illustrate where Vigil’s shares could trade 5 years out from now.

I’d also note that I have tried to outline reasonable valuation and growth scenarios. This comes at a time when the market is willing to price many stocks at unreasonable levels. One example is Veeva Software which is trading at above 10x sales. Ascom who is one of Vigil’s larger competitors trades at 3x sales. While I am not suggesting that Vigil should be valued at the same multiple as a SaaS company (due to a revenue mix that includes hardware and services, and not just software), I do think it illustrates how highly valued some equities currently are. 3x Vigil’s projected sales of $10.9M would suggest a share price of $1.75, while 5x would suggest $2.91.

The Company’s website: http://www.vigil.com/

Author Ownership: Yes TSXV: VGL

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