|Shares Out. (in M):||155||P/E||6.0x||6.0x|
|Market Cap (in $M):||214||P/FCF||NA||NA|
|Net Debt (in $M):||0||EBIT||0||0|
I am recommending a long position in Dundee Capital Markets ("DCM"). This is a relatively simple idea but one that offers investors the opportunity for a 150%+ return over a 6 month to 1 year time horizon with low risk of long term permanent capital loss. All of the information in this write-up comes from the Company's prospectus filed on Sedar at the time of its spin-off.
DCM is a full-service investment bank in Canada that has advisory, underwriting, research and trading, principal trading and asset management businesses. It currently trades at 1.1x estimated end of year tangible book value and the balance sheet is clean and relatively transparent. Net tangible capital is composed of liquid securities. In my base case I estimate that it will earn 23 cents per share in 2011, translating to a 6x earnings multiple at the current price and a 21% return on tangible common equity. In 2009 DCM earned 16 cents (20% ROTCE) and in 2010 it earned 21 cents (23% ROTCE).
On the downside, it seems unlikely that an investor at the current levels will have permanent capital loss. It is currently trading close to tangible book and it is unlikely that DCM will lose money even in a much tougher operating environment because ~50% of the expense base is composed of variable compensation, which the company can easily reduce should revenues weaken.
The stock also offers several opportunities for additional upside that are not factored into the above earnings.
Firstly I think there is a decent probability that management and / or the majority 49% holder, Dundee Corporation, would like to ultimately buy out all of DCM. By way of background, Dundee Corporation was the largest holder of DundeeWealth, which is a diversified investment vehicle in Canada controlled by the successful investor Ned Goodman. DCM was spun-off of DundeeWealth earlier this year when Bank of Nova Scotia acquired the ~80% of DundeeWealth that it did not already own. In an interview found at this link: http://www.dundeecorp.com/, Ned Goodman discusses DCM and hints at the possibility of an ultimate management buyout. Dundee Corporation also uses DCM for deals and should do so in the future, which gives the broker more legitimacy than it would have otherwise.
Secondly, DCM possesses a great call option on higher gold and precious metals prices that does not appear to be at all factored into the current stock valuation. It has an asset management business that invests in gold, gold derivatives, gold miners and other precious metals that consumes very little if any of the balance sheet. It earns management fees as well as performance fees on these assets, making it unique amongst the Canadian brokers in its peer groupe. I have not included these performance fees in my base case earnings for 2011, but this in reality has material value given the impact to earnings if precious metals prices rise.
Lastly, as an investment bank focused almost entirely on Canada, DCM is highly levered to the upside on the market values of natural resources companies. Should resources prices continue to rise, I would expect deal activity, trading volume and principal trading gains to continue to rise. Conversely, should they fall, DCM common stock is protected by its balance sheet value.
The situation appears to exist because the stock is still "off-the-radar" for most investors. The entity only recently spun-off from DundeeWeath (DW CN) in early February 2011. The balance sheet metrics and income statement metrics do not yet show up on Bloomberg, Capital-IQ, or any comp sheets for brokers. It appears that most investment folks even in Canada had not heard of or spent much time looking at the stock. Management has not yet received their options grants and therefore has not tried to promote the stock. The company does not yet have its own independent website, let alone an investor relations site. There is also no investor presentation or investor relations point-person available which makes it harder for typical investors to get comfortable with the business.
What is it worth? Comparable brokers in Canada including Canaccord Financial (CF CN) and GMP Capital (GMP CN) trade at 3x to 4x tangible book value and 11x to 13x expected 2011 earnings, and This would place DCM's valuation at between $4 and $5 (170% to 240% premium to current price) based on end of year TCE per share of ~$1.30. There have been acquisitions of Canadian brokers at multiples substantially higher than these prices. For example Thomas Weisel bought the Canadian broker Westwind in 2007 for $154M, or a 7.5x multiple of its $20.5M of tangible capital.
What are the risks? Investing banking is a market-sensitive business making it difficult to predict earnings. Fortunately it appears that DCM's underwriting business is off to a strong start this year (up 10% vs. Q1 last year) based on league tables, and higher levels for commodity prices relative to last year should be leading to higher trading volumes and more principal trading opportunities. Should commodity prices fall, earnings will likely take a hit. A significant mitigating fact here is that this business is highly profitable and thus has significant variable costs. It spent 60% of its revenues in 2010 on compensation and professional fees. These fees should flex downwards should revenue fall, which should enable DCM to still be fairly profitable, even in a more difficult operating environment.
Another risk is that management is either not incentivized to get the stock price higher, or even worse tries to tank the stock to buy it out at a cheaper price. Thus far they have been very brief with investor communication, and for the time being are somewhat discouraging to new investors. I expect this attitude to change once they receive their stock options, which I anticipate happening within the next quarter. Also, Dundee Corporation is independent from management and has a substantial investment in the equity, which should prevent management from playing any games to keep the stock price artificially depressed.