The Becker Milk Company (TSX: BEK/B) has lots of things to like about it:
- 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.
- 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.
- Becker is small and likely underfollowed as a result. The market capitalization of Becker is $28 million. The company only has five employees.
- 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.
- 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:
- 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.
- 85% of Becker’s revenue comes from Mac’s which poses significant concentration risk.
- 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.
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.
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.
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%.
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.
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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