Redishred Quick Update – $KUT.v

It’s been a minute since I update Redishred. You can view my original post here. The share price has performed reasonably well, although it has underperformed the TSX over the last 5 months.

Here is KUT relative to a couple of indexes and the most talked about disruptor.

Update

Since posting the company has purchased American Security Shredding. Highlights of the transaction:

  • Price $5.15 mil including potential earn outs of $3.4 mil for a total potential price of $8.55 mil
  • Revenue of $4.1 mil in 2020, run rate revenue of $4.6 mil USD
  • 32-35% adjusted EBITDA margins (a bit higher than KUT currently) or $1.4 – $1.6 mil
  • Using full earn out the transaction is valued at 1.8x rev and 5.7x ebitda

They have also announced and closed a bought deal with the month of December. They raised $8.6 mil at $0.88 per share. This equals about 12% dilution. The raise was clean with no warrants and insiders participated in about 5% of the raise.

Profitability Expectations

My estimate (with stable paper prices) is that KUT can generate $12-13 mil in EBITDA (aka bullshit earnings) as a steady state run rate. I think the most they would be comfortable leveraging the balance sheet is 4x EBITDA. Being overly conservative and removing the entire cost of American Shredding, I believe they KUT has about $25 mil available for acquisitions. This of course doesn’t include any additional earn outs that have to be paid for the Richmond or Atlanta acquisitions. It also doesn’t include any cash generated in the mean time.

Per Share Numbers

Most of the roll-up strategies seem to fail or the share price underperforms investors expectations. Focusing on per share numbers is critical for a company like KUT.

Though the consolidated numbers are growing the per share numbers are not growing as fast. There are a few reasons why I think the per share numbers will grow fast enough to warrant a position.

  • The pandemic is masking the overall profitability of the business to some degree.
  • The amount of incremental dilution required to move the needle goes down as corporate location store count goes up. The leverage ratios remain stable, while the dollar amount grows.

Valuation

At today’s price you are getting KUT for 8-9x EV/2022 est EBITDA. I think they have some additional operating leverage tied to reopen as well they are cashed up and likely to continue the cadence of acquisitions.

Anyone care to comment on KUT?

Thanks,

Dean

*long KUT at time of writing

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O&G Activity – Canada

Sorry for spamming you, I discovered an error in this post after I published it.

I’ve previously put some thoughts O&G activity internationally and in the USA, today I put some things together for Canada.

For those unaware, Canada has the 3rd largest oil reserves in the world (mostly) via the oilsands. There is also multiple LNG projects being commissioned and built in BC to send our natural gas to more expensive markets globally. These are highly complex, multi year, multi billion dollar projects.

British Columbia, Alberta, and Saskatchewan make up the vast majority of activity, so I will focus on activity in Western Canada. Below is the rig count for Canada, it shows how much of the overall activity is based in AB.

With so much business activity based on cyclical demand for hydrocarbons, Alberta is known as a boom/bust economy. As an Albertan, I understand how important the oil and gas industry is to our local economy. Local businesses compete with the higher wages present during the boom times, but also benefit from the increase in household income. When activity is strong, I notice an increase in our infamous rig rockets around the streets. For those who don’t know what a rig rocket is have a look below for a good example.

As a Canadian, I realize that our country’s largest export is crude and refined petroleum products. Depending on the year and how you add up the various products, they make up 15-20% of our exports. Regardless of your political leanings or views on the impact on the environment, a sharp decrease in price or activity (or both) will be harmful for Canada’s budget (at least in the short to medium term).

https://oec.world/en/profile/country/can#yearly-exports

Though WTIC is a decent indicator for global prices, for Canadians (and particularly us out west), we like to focus on Western Canadian Select (WCS) and a more localized Natural Gas price (say Alberta Nat Gas). WCS is a lower quality oil and it’s further away from major markets than WTIC and trades at a discount to WTIC. It’s also tends to be more constrained by pipeline capacity than other benchmark oils.

WCS wasn’t established until 2004, so that is as far back as we can look.

You can see from the chart there were 2 big drops in the chart at the end of 2018 and during the initial days of the pandemic.

The WTIC and WCS spread makes headlines sporadically when it’s at the extremes. The highest spread was in late 2018 when the difference was over $50. The spread has been as low as $5-7 but usually doesn’t last long. $15-25 is a more typical difference between the two.

Production costs

It’s hard to determine the exact marginal cost for a barrel of oil. It’s obviously project specific as well it’s tied to the available pipe or rail to transport it to a refinery. This may be an over simplification, but I think of Canadian oil as “more expensive” than many other sources. Having said that, it (at least historically) tended to be more “business friendly” out west. So these types of qualitative data points need to be considered if you are a large oil producer. Maybe it’s more expensive to produce in Canada, but there may be more stability.

I grabbed this chart from a 2017 IMF Working Paper. I also attached the paper below.

History

The history of oil production in Canada is colorful. Here are just some of the more memorable recent events I can recall related to activity in Alberta:

  • “Bitumen Bubble” and subsequent impact on Alberta’s budget in 2013.
  • WCS spread reaching $50/barrel in 2018.
  • WCS trading under $10 (and lower on a daily basis) in 2018 and 2020.
  • WCS trading over $100 in 2008 when we were “running out of oil”.
  • The rig count in Canada peaking over 600 during the cold season (2004-2008) and (2011-2013).
  • Production limits mandated by the NDP government in response to the increased spread between WTI and WCS due to mainly to limited pipeline capacity.
  • Keystone pipeline (important for taking AB crude to refineries in the US) commissioned in 2010.
  • Keystone pipeline rejected by Obama administration in 2015.
  • Keystone pipeline production resumption with UCP gov taking an equity interest in 2020.
  • Biden revoking the permit for the Keystone pipeline in 2021.
  • Many others being commissioned, started, stopped, re-started, etc.

For some additional context Alberta is typically a Conservative province (except our recent NDP stint) with our national leadership tends to swing more Liberal. I’m not going to into detail, but the oilsands and hydrocarbon production are always topical. There is a very wide dispersion of public opinion regarding the oil and gas industry, more specifically the oilsands and production of oil. It has been labeled “dirty oil” by many.

Investing Implications

If you managed to make it here, you are likely saying to yourself “ok already… get to the investing stuff, I’m here for the rocket ship emojis not some history lesson on Canada”. This is all just background for anyone interested in investing in O&G companies, albeit it can be boring.

Given the price of oil, the rig count is too low compared to previous cycles. Similar to other parts of the world, large producers have been reluctant to deploy significant amounts of capital to replace the declining reserves. It should be noted that many large producers in Canada have 30+ year reserves, so they may not have a large sense of urgency.

The rig count is seasonal as it’s strongest in the winter when the ground is frozen and the rigs can get out into the bush where there aren’t roads.

The ESG movement and transition to EV has taken center stage for many firms (especially those who look to gather more assets). My opinion is that we will be tied to hydrocarbons longer than we think and this last cycle(s) coupled with covid has left us underinvested relative to our demand picture.

Here is the 5 year performance of iShares U.S. Oil & Gas Exploration & Production ETF (IEO) vs iShares US Oil Equipment & Services ETF (IEZ). IEO is a little over break even and IEZ is way under water.
Here is the 1 yr chart.

This of course can be misleading. Who knows if I picked the appropriate times to compare these. You could go back longer and come to a different conclusion, so be warned. In reality we should be looking at valuations on an absolute and relative basis along with the share price and fund flows.

Having said that, I believe that there may be an opportunity to invest in companies tied to O&G market activity (not production alone) that will produce (in aggregate) reasonable returns relative to risk.

For my portfolio, I look at investing in O&G companies as a top down bet. I don’t know all the nuances of each cycle, so I take a basket approach. I try to be diversified geographically and by product/service. This does leave me with more companies to follow and can stretch my bandwidth at times. I currently own McCoy Global ($MCB.to) and Pulse Seismic ($PSD.to) that are directly tied to oil and gas activity. As well, I have a position in Macro Enterprises ($MCR.to) that benefits from overall investment in oil and gas infrastructure.

I’ll go over how I benchmark this trade/investment in a future post.

Anyone else follow the rig count or have anything to add?

Thanks,

Dean

*long $PSD.to, $MCB.to, $MCR.to

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Cipher Pharmaceuticals – $CPH.to

Price: $1.80 CAD / $1.39 USD

Shares outstanding: 26.5 mil

Market Cap: $37 mil

Enterprise Value: $21.3 mil

*Shares trade on the TSX in $CAD, but they report in $USD. All values are in $USD unless stated otherwise.

I’ve built a reasonable sized position in CPH over the last 9 months and welcome some feedback on the idea. To me the idea is summarized by a cheap business, a strong presence with one of their main products, run by a prudent allocator with a couple of paths to higher valuation.

The company is a former market darling from years ago when the launch of Absortica drove revenue and cash generation to new highs. As such, the expectation was for the success to continue. CPH traded at over 10x rev at one point (ah the good ol days of Canadian specialty pharma). The launch of a generic version of Absortica and some other less than stellar moves with a large cash pile have left some with a serious case of PTSD when you mention CPH.

Background

Cipher Pharmaceuticals Inc. operates as a specialty pharmaceutical company in Canada.

Its commercial products include Epuris (CIP-ISOTRETINOIN), a formulation of the active ingredient isotretinoin for use in the treatment of severe acne; Ozenoxacin to treat adult and pediatric patients with impetigo; Actikerall, which is indicated for the treatment of palpable or moderately thick hyperkeratotic actinic keratosis; Vaniqa, a prescription cream that reduces the growth of unwanted facial hair in women; BRINAVESS, a treatment for sinus rhythm in adults; and AGGRASTAT, an intravenous anti-platelet drug.

The company’s licensed products comprise Absortica (CIP-Isotretinoin); Lipofen (CIP-Fenofibrate), a formulation of the active ingredient fenofibrate used for the treatment of hyperlipidemia, a cholesterol disorder; and Conzip/Durela (CIP- Tramadol), a formulation of the active ingredient tramadol for the management of moderate to moderately severe pain.

Its pipeline products also include Trevyent, a vasodilatory prostacyclin analogue to treat pulmonary arterial hypertension; CF-101 for severe plaque psoriasis and rheumatoid arthritis; MOB-015, a topical formulation of terbinafine for the treatment of onychomycosis; and DTR-001, a tattoo removal cream. Cipher Pharmaceuticals Inc. was founded in 2000 and is headquartered in Oakville, Canada.

Income Statement & Cash Flow

In the short term Absortica and Epuris results will drive the income statement. Both are used to treat severe acne and are not subject to a typical business cycle, whatever that is. The ISOTRETINOIN market as a whole continues to expand year after year.

As mentioned earlier Absortica faced (and continues to face) generic competition. CPH has partnered with Sun Pharmaceuticals to distribute Absortica in the US. Sun has recently launched Absortica LD and Absortica AG to maintain their marketshare. The agreement with Sun ends Nov 2022, I am operating under the assumption that they continue to work together after Nov 2022. Regardless, this has been quite a fall for Absortica.

I’m not 100% certain I have the correct data when looking before 2018.

The ttm has seen sales of about 9mil USD with Q3 2021 being the lowest at 1.4 mil. On the most recent conference call, the company mentioned to look at Q2 2021 and Q3 2021 together as a better indicator of what to expect from Absortica. These two quarters have seen sales of 3.8 USD.

Epuris is the same product although CPH owns the commercial rights. Since the peak sales of Absortica in 2016/17, Epuris has continued to gain market share (now over 40%) and sales, albeit not quick enough to offset Absortica’s decline. So far, there hasn’t been significant competition for Epuris.

CPH has recently launched Epuris in Mexico with their distribution partner Italmex which should help offset any further weakness in Absortica sales. This is a large opportunity for CPH, although it will take time for this to show up on the income statement.

There are some additional licensed sales, mainly Lipofen. They have a small amount of product sales from prior Cardiome products.

Costs have come down and margins have been maintained with the change in leadership (more to come).

Balance Sheet

The company has effectively no debt and 15 mil in cash. They continue to generate cash every quarter with this amount of revenue. Removing the cash balance from working capital leaves you with a very asset light business. TTM ROE is north of 20%.

With the purchase of the Canadian products from Cardiome in 2018, CPH also acquired a bunch of tax loss pools. 200 mil that expires up to 2033. As well there is an additional 50 mil USD that does not expire. This leaves a total of 250 mil (when purchased in 2018).

From the 2020 Annual Report:

“The Company has non-capital losses of $210,596 [2019 – $211,390], investment tax credits of $13,860 [2019 – $13,587] and SR&ED expenditures of $55,962 [2019 – $54,859]. The non-capital losses expire in varying amounts from 2026 to 2039. The investment tax credits expire in varying amounts from 2023 to 2032.”

Management

There was a unforeseen change in leadership in 2016 with the then CEO stepping down. That was followed by a few more changes in CEO before the board appointed Craig Mull as interim CEO in 2019. Craig took over not long after the Cardiome acquisition. Since taking the helm, Craig has done a good job brining operating costs in line with the new reality for CPH.

They have also continued to execute the NCIB for up to 10% of the outstanding shares. CPH has also managed to ink a co-promotion agreement with Verity Pharmaceuticals for the marketing, sales and co-promotion of Brinavess, Aggrastat and Trevyent (all of which came with the Cardiome acquisition in 2018). This provides some additional upside to CPH. These products are referred to as CPH’s hospital products. This is a fairly significant deal as there has been little revenue contribution from the products so far.

On the last conference call the CEO mentioned that they are looking to purchase cheap(ish) legacy assets with the cash. I view this as positive. I would rather them do something with the cash then sit on it. So far, the CEO has proven himself to be a good steward of capital.

Share Structure and Ownership

There are about 26.5 mil shares outstanding (26.9 mil fully diluted). They have a clean share structure with little potential dilution.

  • The founder (Dr. John Mull) still owns 37% of CPH. He is also on the board.
  • CEO owns about 2% and is Chairman.
  • Other board members own about 2%.
  • Total insider ownership is 40%

Pipeline – some additional upside

Treprostinil Sodium (Trevyent) was mentioned earlier and will be marketed and sold in Canada by Verity.
The MOB-015 continues to work through the regulatory approval process. The total prescription market in Canada is 85mil. They are anticipating approval in early 2023 and launch soon after.
The CF-101 is currently in phase 3 now. Over 1 million Canadians have psoriasis. The product appears to have a high safety profile based on the Annual Report for 2020.
The Tattoo removal cream product has a huge TAM, although it is still in very early stages.

Why is CPH potentially mispriced?

There have been some misteps in the past that have left investors with a poor perception of CPH.

  • Trulance settlement with Baush regarding a breach in contract and resulting in CPH taking an 5.4 mil charge.
  • Epuris (their main cash generating product) could face future competition from a generic product.
  • Continued decline in Absortica sales and not sure where/if it bottoms.
  • Frequent CEO changes.
  • The purchase of Canadian business of Cardiome in 2018 failed to materialize meaningful revenues.

Valuation

Despite the positive steps being taken, CPH trades at less than 2x EV/adj EBIT. The P/E is 3-4 if you remove the one time items. It doesn’t take much imagination to see a re-rating in the future.

The company has generated almost 10 mil in cash over the ttm if you exclude the one time items (legal settlement and lease extinguishment). This would equate to 2x EV/FCF, although Q4 2021 is against a tough comp so I don’t expect them to beat it.

Needless to say, it’s cheap. I don’t believe that you really need to know the exact multiple to determine that the market has low expectations for CPH.

Summary

CPH is unwanted by many. It’s not sexy. It isn’t “ESG”, growing gangbusters, curing covid, or somehow involved with crypto. The colorful history, illiquid shares and short term uncertainty have created a favorable risk/reward set up in my mind. Investors are worried about the future of the company with declining Absortica revenue and a disproportionate amount of the future relies on Epuris. They have made a few moves in the last 12 months that lead me to believe that they will be less reliant on Canadian sales of Epuris than the market anticipates. I believe that CPH is a more typical low risk, high uncertainty set-up.

Anyone else own CPH or want to comment?

Dean

  • the author is long CPH at time of writing

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