In this newsletter, I share the most intriguing investment ideas I've come across in the past week from a variety of sources, including Value Investors Club, various investing blogs, hedge fund letters, and more. I aim to present you with concise and easily digestible investment idea summaries that quickly capture the essence of the thesis.
This week's newsletter includes:
Short Idea: Otter Tail (OTTR) - Overearning regulated utility/pipe manufacturer.
Enstar Group (ESGR) - Cheap insurance run-off company.
Telephone and Data Systems (TDS) - Potential sale of mobile network operator.
Magellan Aerospace (MAL:TO) - Aerospace supplier with expected rebound in profitability.
Santos (STO:AX) - Undervalued Australian O&G giant.
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Short Idea: Otter Tail (OTTR, $2.9bn)
Otter Tail is a Minnesota-based regulated utility that also owns a municipal pipe manufacturing business. The company currently looks very expensive due to the overearning pipe manufacturing segment. Valuing OTTR's regulated utility business in line with peers, the company's pipe manufacturing segment is trading at a massive 40x+ pre-Covid EBIT. The short opportunity exists because the pipe manufacturing business has been materially overearning in recent years driven by temporary disruptions in the supply chain, including back-to-back freezes, a hurricane, and COVID, all of which led to elevated pipe pricing. Since 2019, the pipe manufacturing segment's EBIT has increased over 10x, while total OTTR EBIT has increased by nearly 3x. However, the tailwinds have subsided and segment’s margins have already started normalizing due to rapidly falling municipal pipe prices. This price decrease is expected to be prolonged and further catalyzed by distributor inventory destocking, with full normalization expected by 2025. Despite this, the market continues to value OTTR at peak earnings. Valuing the pipe manufacturing business at a much more reasonable 12x normalized EBIT (still 65% above pre-Covid levels), OTTR would be valued at $54/share, compared to $70/share currently. Full OTTR write-up on Value Investors Club (free guest account is required).
Enstar Group (ESGR, $3.7bn)
Enstar Group is an insurance run-off company that acquires portfolios of discontinued insurance lines. ESGR operates a structurally-advantaged business model as the company acquires assets from motivated sellers and manages them more effectively than traditional insurance companies due to its expertise in claims management. Despite a much-improved industry environment in recent years due to higher interest rates, reduced competition, and an increasing number of insurers looking to sell their run-off portfolios, the company trades at historically low valuation multiples of 0.9x understated GAAP TBV and 5x run-rate net income. This valuation is undemanding for a high-quality business with a strong track record of growth (book value CAGR of 15.7% since 2003) and capital allocation, with 30% of outstanding shares repurchased over the last 3 years. Valued at a more reasonable 1.5x economic TBV, which is in line with industry median levels, the company would be worth 150% above the current share price levels. The opportunity exists because ESGR seems to be overlooked by insurance-focused investors, given that its business model and financials significantly differ from those of traditional insurers. Incentives are well-aligned, with insiders holding a 35% ownership stake. Full ESGR write-up on Value Investors Club (free guest account is required).
Telephone and Data Systems (TDS, $2.0bn)
This is an unusual and interesting potential company sale situation. Telephone and Data Systems is a holding company that owns an 83% stake in the mobile network operator US Cellular (USM). The controlling Carlson family has recently launched strategic reviews in USM and TDS, with the sales of the companies among the potential options. Both USM and TDS have popped 100%+ since the announcements, reflecting the market’s previously ascribed valuation discount due to the controlling stake held by the Carlson family and skepticism about its willingness to sell. There are several aspects suggesting that USM could get sold at a substantial premium to current prices:
The controlling family appears incentivized to sell USM as the company is highly levered (6x net leverage ratio). This will hinder its ability to pursue copper network overbuilding with fiber.
There is also a strong financial incentive given that in a sale scenario the controlling family could net over $400m in proceeds. These proceeds could generate $20m+ in annual interest in a simple money-market fund - materially more than the current dividend of $11m that the controlling family receives from USM.
A partial company sale does not look like a feasible option given that in a divestiture/asset sale scenario tax leakage would most likely be significant and/or the company could face a lengthy process due to potential regulatory issues. A potential sale to one of the three major wireless companies (VZ, TMUS and T) seem be the most likely options given that VZ is USM’s largest JV partner while TMUS has a good geographic fit with the potential target. SOTP valuation indicates that USM might be worth $65/share (56% upside) based on the value of company’s tower portfolio, partnerships, unused spectrum and wireless business. This valuation would imply a price target for TDS of $35/share (95% upside). Downside to TDS pre-announcement price stands at 57%. Full TDS write-up on Value Investors Club (free guest account is required).
Magellan Aerospace (MAL:TO, C$430m)
Magellan Aerospace is an aerospace supplier that produces aircraft airframe components for both commercial and defense end-markets. The company appears to be on the cusp of an earnings reflection and currently trades at a historically low 3x normalized EBITDA. The share price of MAL has declined significantly since the onset of Covid, primarily due to deteriorating profitability. This decline has been driven by the weakness in commercial aircraft production, as well as supply chain impediments and resulting cost inflation. Magellan's EBITDA dropped from an average of $156m displayed during 2015-2019 to $36m in 2022. However, with the expected increase in commercial aircraft production and the normalization of cost headwinds, Magellan is likely to return to historical profitability levels in the upcoming years. Company's topline is anticipated to benefit from a ramp in widebody commercial aircraft production. On the cost side, Magellan is expected to benefit from normalizing supply chain conditions and better overhead absorption as commercial aircraft production recovers. Additional cost savings are expected from ongoing contract pricing negotiations with suppliers. On a normalized EBITDA basis, Magellan is trading substantially below its peer Spirit AeroSystems which is valued at 6x 2025E EBITDA. Applying the same multiple to Magellan would imply a target price of $12.5/share, representing a 67% upside. Incentives are well-aligned here, with the chairman owning 75% of outstanding shares. The downside is partially protected by Magellan's solid balance sheet, with limited debt, TBV of $11.75/share (compared to the current share price of $7.50), and NWC of $6/share. Full MAL:TO write-up on Value Investors Club (free guest account is required).
Santos (STO:AX, A$25.3bn)
Santos is Australian O&G exploration and production giant that owns LNG, pipeline gas and oil assets primarily in Australia and North America. Despite the highest expected EBITDA growth in its peer group, Santos is currently trading at 4.2x 2023E EBITDA vs 4.6x for the closest peer Woodside and 5-6x multiples for US-listed comps. However, there is a potential near-term catalyst that might help close the valuation discount. Investment manager L1 Capital has recently sent a letter to the company, pushing it to launch a strategic review. The activist has proposed a separation of Santos’ Australian/North American oil and gas assets into another entity, leaving the remainCo as a pure-play LNG company. The transaction would address several key issues that have caused Santos to underperform vs its peers over the last three years, including smaller dividend payouts as well as under-appreciated LNG growth story. The separation would allow the two entities to have different capital allocation policies, with the new entity attracting Australian domestic dividend-focused investors and the remainCo focused on LNG asset growth. Given Santos’ leading portfolio of tier-one, low-cost and large LNG assets, the LNG-focused remainCo would alone be likely be valued more than Santos’ current market cap. L1 Capital has suggested that the combined company might be valued at A$10.50/share vs the current share price of A$7.80/share (35% upside). Full STO:AX pitch from L1 Capital.
Santos $STO is a nice catch👍