Terravest Industries (TVK.TO / TRRVF) -high quality, undervalued microcap with a phenomenal manageme
The first line on you see on the Investor Relations page on Terravest’s website is: “Our objective is to grow free cash flow per share through organic growth and acquisitions.”
You don’t see that often!
This business was put on my radar after reading an early October VIC writeup followed by the other 2018 VIC writeup, and a presentation by publicly traded Clarke Inc. (CKI.TO), currently Terravest’s largest shareholder.
Terravest (disclosure: long) is a relatively simple business and story, as evidenced by the sentence I highlighted above, that seems to be managed by some very smart, capable and shareholder friendly managers.
The other aspects I like include illiquidity (TRRVF is a sub-$300mm market cap business with over 30% of the float owned by insiders), no analyst coverage, and an unwillingness of the management team to give guidance or host conference calls. As a result, Terravest is right up my alley in terms of investment criteria I look for; a boring, underfollowed microcap operating a niche business with a phenomenal management team running the show, trading at a cheap valuation.
The above criteria can occasionally invite mispricings, and despite shares being up over 200% since 2014, TRRVF still appears to be undervalued relative to its long term potential and strong capital allocators at the helm.
At a current share price (CAD) of $14.41, and $19.1mm fully diluted shares, TRRVF has a market cap of $275mm. With $9.5mm in cash and $109mm in debt (excluding about to be retired convertible debentures), total enterprise value comes to $375mm. Free cash flow for 2018 and 2019 came out to be $27.1mm and $30.7mm, giving Terravest an EV/FCF multiple of 12.1x using 2019 figures. While not absurdly cheap at first glance, multiples have increased recently as the shares jumped about 18% in the past week alone, and as outlined below, it appears we are in the early stages of this growth story.
Company provided multiples come out much lower after excluding convertible debentures from the EV calculation, and management likes to use a price/FCF figure as opposed to EV/FCF. Management defines free cash flow as ‘cash available for distribution’ or net income +/- changes in working capital – maintenance capex. Of note, I’ve seen other writeups/investors value the company similarly, excluding growth capex and using p/FCF. I’m being a little more conservative I guess using an EV/FCF valuation. The figures below are $CAD from the company’s 2019 investor presentation (not available on the website, but comes up during a google search).
So with that as a backdrop, let’s get into the business and some of the key value drivers highlighting what makes this an attractive opportunity.
Terravest describes themselves as a diversified industrial company that sells goods and services to various end markets including energy, agriculture, mining and transportation. The company manufactures pressure vessels; fuel containment units; propane trucks and trailers; and complex wellhead processing equipment for the oil and gas industries which involve vessel fabrication, electrical work and assembly. Terravest has three segments; fuel containment, focused on downstream storage and transport of fuels (responsible for 60% of EBITDA), processing equipment, which is used at the wellheads of natural gas wells to separate NGLs and remove frac sand (responsible for 37% of EBITDA) and a service segment consisting of Diamond Energy Services that operates 21 servicing rigs (making up 3% of EBITDA). The company dominates their niches, serving as the #1 manufacturer of home heating oil products in North America, the #1 manufacturer of propane and liquid natural gas transport vehicles in Canada (and #3 in the US), and the #1 manufacturer of wellhead processing equipment in Canada. Terravest has a long 65 year operating history, and has now built themselves up to be a critical supplier to the North America heating oil market.
Terravest now plays a part in all aspects of the fuel infrastructure supply chain, from storage to transport to in-home service.
The above, combined with manufacturing and customer diversity reduces the company’s exposure to cyclical downturns. Terravest’s near monopoly position in some of their business segments as well as scale allows them to accomplish a few things that smaller, less well-capitalized competitors (typically mom and pops) can’t do such as cross selling commercial products into their end markets, spreading fixed costs over a larger revenue base as acquisitions are made, and surviving tough industry conditions. Today, Terravest boasts some of the largest and most well known businesses in the world as customers, and their revenue breakdown consists of 67% being generated in Canada with the remaining 33% from the US.
So how did we get here?
The wheels for Terravest’s current story were put into motion in 2007 following a disclosed 10% ownership stake and board seat by current Clarke Inc. (CKI.TO) Chairman George Armoyan (an experienced Canadian investor). Prior to being a corporation, TRRVF was an unfocused income trust with a hodgepodge or unrelated and underperforming assets. It wasn’t until 2012 that the business really began to transform. Armoyan continued to acquire shares and control, filed to become a corporation, suspended the dividend, sold off-non core assets and whittled the company down to two related businesses – Diamond Energy Services, responsible for servicing rigs, and RJV Gas Field Services, responsible for manufacturing wellhead processing equipment. The former management team was outed in 2012, and replaced by former CEO Dale Laniuk, who was the founder of RJV Gas Field Services at the time.
The acquisition strategy didn’t kickoff until 2014, but in that year, Terravest acquired Gestion Jerico, where former 25% owner Charles Pellerin was brought onto the board and now sits as Chairman. This is also when current CEO Dustin Haw (former VP of Investments at Clarke Inc.) joins the board. Gestion Jerico, along with RJV are now both core segments of the Fuel Containment and Processing Equipment segments.
Today, Terravest grows organically, but they are mainly focused on acquiring businesses at cheap multiples of free cash flow, integrating them into their operations and managing them for growth. Revenues have grown at a 12% CAGR since 2015, with blended EBITDA margins coming in at around 16-18%. This part of their business strategy is where the growth and cash generation comes from, and the management team has shown extreme discipline and shrewdness when making acquisitions in terms of the businesses they buy and the multiples they pay.
A quick look at the last 5-6 deals done show that EV/FCF multiples paid by Terravest are in the low single digits, having reached 6.0x only once in the past few years. This is because TRRVF is typically purchasing businesses from retiring or distressed owners (a recent business was acquired out of bankruptcy), enabling them to garner low multiples, cleanup operations, and achieve high returns on their cash outlay. The company typically uses around two turns of debt to acquire a business, so the levered multiples are even cheaper than mentioned above.
To illustrate, for six of the past eight acquisitions (excluding Countryside Tank and Argo Sales, yet to kick in meaningful FCF), Terravest spent a total of $95 million (including growth capex) with those acquisitions having generated $28mm in UFCF. Assuming 2.0x debt/EBITDA used in the deals, Terravest equity investment would be around $35mm, bringing in free cash flow to equity of $19mm, and lowering the multiples even further. Not bad at all. While there is competition in the space for acquiring businesses that earn $5-8mm in EBITDA, Terravest stays disciplined with their purchase criteria and usage of debt, unlike PE firms who in the past have used 4+ turns to make acquisitions in the space. Most of the time, cyclical end markets + high leverage is a recipe for disaster, and this is in fact how TRRVF came to acquire Argo Sales from a private equity shop in December of 2019.
While it’s always important to dig into why a specific opportunity exists, one has to look no further than Terravest’s corporate history to see that historical financials hardly paint a rosy picture, and management’s non-promotional style (no presentations, guidance, IR department, conference calls) have kept the valuation cheap despite the cash generation ability of the company and managements stellar capital allocation skills. It doesn’t help that there is a large shareholder (providing limited float) or that Terravest is associated with all Canadian oil and gas businesses, but the reality is that this is cash flow generative business at a cheap valuation being run by a shareholder friendly management team.
As mentioned above, Terravest is being lumped into the energy and commodities buckets given their exposure to oil and gas prices as well as steel prices through their end customers. While I wouldn’t necessarily view this as a positive, management uses the cyclical and seasonal nature of their business to their advantage, boosting inventory before periods of expected demand, spending on growth capex to realize efficiencies and enhance their competitive positioning, and repurchasing shares during periods of share price volatility. During the start of the energy market downturn in 2016, Terravest experienced sharp declines in revenues, EBITDA and margins, but was still able to generate around $6mm in free cash flow, and used some of that to repurchase over 1 million shares in 2016 (5% of total shares outstanding).
If you were to sit down and try to outline the most effective way to roll up a fragmented, cyclical industry and integrate the businesses into your operating company while allocating capital for the benefit of shareholders, it would be hard to come up with a playbook that provided better results than the one management has been following over the past eight years. The management team at Terravest is a cut above most microcap management teams evidenced by the return generated for shareholders over the past few years. In my view, we are in the beginning of such value creation, with shares still available at cheap prices.
Moving forward, the size and timing of acquisitions will be tough to predict, but management has talked about a strong pipeline and long runway for growth. In addition, it wouldn’t be difficult to project continued free cash flow generation moving forward. One positive aspect of the uncertainty surrounding revenue/margin/cash flow predictability and potential associated share price volatility will be the willingness of the management team to acquire shares at cheaper valuations as the company balances organic growth with the integration of new businesses.
Despite continued negative industry conditions (Stated in the most recent press release: ‘The Western Canadian energy market continues to be challenged and management is not anticipating a reversal for fiscal 2020’), for fiscal 2020, management is expecting further incremental improvement driven by continued strong demand for its LPG, NGL and anhydrous ammonia storage and distribution equipment, as well as a recently completed major capital project (the move to a new manufacturing facility) that should improve the efficiency of its petroleum tank manufacturing. Additionally, management expects a positive contribution from recent acquisitions, including Argo Sales and Countryside Tank.
The timing, size and impact of acquisitions makes this a tough business to forecast in a linear way, but I put together a quick back of the napkin model to illustrate the potential growth of free cash flow (or as management calls it, ‘cash available for distribution’) moving forward. In addition, working capital changes make it tough to forecast this cash flow. I don’t even know how to estimate working capital changes for 2020 and 2021.
At just 12x 2020-2021 free cash flow, TRRVF shares would offer anywhere from 15-35% upside from today’s prices. However, should the multiple increase to say 15x or more to reflect the continued growth in FCF and give credit to the capital allocation skills of the management team, investors would see even higher returns.
One final aspect of the company valuation I’d like to discuss more includes Terravest’s service segment, currently responsible for 5% of total company revenues and 3% of EBITDA. I don’t believe investors are paying much for this segment which has seen material declines in operating performance since 2015 following the downturn of the Canadian energy market. While it may be a stretch, I’d estimate the service segment to be worth somewhere in the range of $15-20mm should a buyer come along, but outside of that, any improvement in revenues and EBITDA are not factored into my valuation and would have a decent impact on total company performance.
Since 2015, revenues have declined from $28mm to $17mm for 2019, with EBITDA declining from $6.5mm in 2015 to $1.6mm today. Customer pricing in the service segment is responsible for the decline, with field rates, rig utilization and commodity prices all significantly impacted as a result of the bear market in Western Canadian energy. Terravest was impacted most from 2015-2016, with revenues declining over 20% and EBITDA being chopped in half. However, during those two years, Terravest still generated a combined $11mm in free cash flow, and repurchased over one million shares from the float and one member of the management team. In addition, cost reduction efforts in the service segment have allowed Terravest to continue to operate despite aggressive bidding practices and lower industry pricing for services.
While difficult to pinpoint exact comps, industry M&A data suggests that transaction prices range from 1-1.5x revenues and 5-6x EBITDA. As EBITDA is a decent proxy for free cash flow (low capex in the service segment), it’s possible that an informed buyer would pay somewhere between $10-20mm today for this segment using trough revenue and free cash flow numbers. Any uptick in commodity pricing or an industry wide improvements would have a significant impact on the service segment and may lead to a return of free cash flow growth moving forward.
Lastly, my total company valuation assumes no benefit from the two most recent acquisitions of Countryside Tank and Argo Sales, nor does it factor in organic growth, buybacks, or improvements in industry conditions. Terravest also pays a $0.40/share dividend ($0.10/share quarterly).
As mentioned above, float is relatively small, with the largest shareholders made up of Clarke Inc., (by the way, the Clarke annual reports/investor presentations make a great read. The business is run by some phenomenal capital allocators with a long history of value creation and a ton of skin in the game. They made a big bet on Terravest before the shares started to pop) Chairman Charles Pellerin, CEO Dustin Haw (former VP of Investments at Clarke Inc.), and board member and former CEO/President Dale Laniuk, also the President and CEO of RJV Gas Field Services.
Chairman and Director Charles Pellerin owns some $40mm in stock, over 40% of which was acquired over the years in the open market. When Terravest acquired Gestion Jerico in 2014 (a business in which Pellerin co-owned), he took the entire payment for his share of the business in Terravest shares. In addition, CEO Dustin Haw owns shares worth nearly 6x his annual salary, while CIO Mitchell Gilbert in charge of finding acquisitions) owns 8x his compensation in shares.
Reading through the management information circular was a plus, as compensation seems incredibly fair, and investors should feel as though the management team is aligned and focused to grow their wealth alongside shareholders. Also, one would think that the integration and closeness of the Clarke Inc., group and team would over the years lead to some shareholder abuse or mis-allocation of capital. To date, there has been none.
By the way, CEO Dustin Haw and Charles Pellerin are only 36 and 44 years old. There is potentially a very long runway for growth with these two at the helm.
There’s more. Terravest has demonstrated some of the most shareholder friendly capital allocation decisions I’ve ever seen from a microcap management team outside of their tremendous acquisition record. In 2012, Terravest repurchased 36% (!) of the business with a $2.75 tender offer, a nearly 80% discount to the stock price at the time. Last year, insiders launched two tender offers to repurchase 10% of shares outstanding at less than 7.0x free cash flow, and to repurchase some of their convertible debentures.
While some of the company’s business segments are subject to cyclical downturns (including the energy segment currently reflecting that), and small companies can be quite volatile at times, I’d feel very confident given management’s track record that they will always look to opportunistically buy back undervalued shares every chance they get.
Of note, a Dec. 11th press release outlining the company’s fourth quarter and year end results also announced the full redemption of all outstanding convertible debentures with a principal amount oustanding of $8.8mm.
I like the opportunity a lot, as it fits squarely within my investment criteria, with the potential for near term upside, and significant share price appreciation over the long term as investors benefit from the growth in free cash flow per share and management’s capital allocation abilities.
Selling pressure from major shareholders – should Clarke Inc., have to sell for reasons unrelated to the economics of the business, I’d view this as an opportunity to be able to acquire more shares at favorable prices
Recessionary environment may impact end markets – despite poor operating results during unfavorable pricing conditions for oil and gas, Terravest has grown their free cash flow per share north of 30% over the past five years, despite terrible industry conditions for many of their end markets
Debt load – using leverage is part of their model to help increase returns from acquisitions, and Terravest is currently levered <2.5x debt/EBITDA
Inability to integrate future acquisitions or turnaround struggling operations – management has a phenomenal history of acquiring businesses and creating value
Low barriers to entry for manufacturing – true, but scale and market leadership allows TRRVF to spread fixed costs over a larger revenue base, keep customers, and withstand industry downturns – mom and pops can’t operate this way
Seasonal and cyclical operations – capital allocation (buybacks) will be useful here
Competition for deals in their space from private equity/other buyers – Terravest has historically targeted small mom and pop operations in fragmented industries that offer little competition for deals. They are typically buying from distressed or retiring owners. I view this space as too small for most PE shops, but also non-sexy which is a plus for TRRVF
Tariffs – impact of these has been felt in the company’s wellhead equipment segment in the form of higher raw material costs (steel). No way around this I guess.
Easy for end users to switch manufacturers – from what I understand, there is a high level of customization involved in Terravest’s products, and the portable nature of transportation tanks helps customers address the need for secure, temporary storage with immediate access – in addition, when you need your product shipped safely and reliably, you’re not going to ‘take the low bid’ and trust another manufacturer with a less stellar reputation
Price of raw materials escalates – may be difficult to pass along to customers
I’ve been going back and forth with management regarding setting up a time to chat. They’ve been very willing to do so, we just haven’t been able to set up a time. The feeling I get is that they enjoy talking to investors. I’m looking forward to updating my thoughts with any new information gleaned from my conversations with them.