Automodular Corp – Special situation investment: 25% expected return

Summary

Special situation uncorrelated with market fluctuation.
25-30% upside in 9-12 months via a liquidation scenario.
Further potential upside in GM litigation.

THESIS

Automodular Corporation (OTCPK:AMZKF) shares are worth C$2.71-$2.86. Market price is $2.15 CAN, a 24.5-30.7% margin of safety to intrinsic value.

(in thousands)

Intrinsic value: $53,690
Market Cap: $41,660
Workout return: $12,030
Return after 15% Canadian Tax: $10,226 (24.5%)

Automodular Corp’s special workout situation offers a chance to earn 25% in one year. The risk-reward scenario is compelling with limited downside and some upside optionality in excess of the 25% expected return. This workout investment is decoupled from equity market fluctuations because value realization depends on the company winding down within the next 9-12 months.

SHORT BACKGROUND

Automodular Corp, based in Canada, is a sequencer and sub-assembler of components installed in vehicles. AM has a contract with Ford (F) ending on December 23, 2014. After that, it will have no further revenue streams and will be in position to disburse to shareholders all remaining assets post liabilities. The company management is shareholder friendly and acts consistently with stated goals of maximizing shareholder value. As of 2013, 22% of shares were held by insiders. A longer discussion of company’s history is irrelevant to this analysis because it will not be a going concern involving future cash flow analysis. Comp valuations are also irrelevant because this is a standalone workout situation.

MARKET DYNAMICS

After GM went through bankruptcy proceedings in 2009, it was able to reduce labor costs from $16B to $5B annually and established a breakeven profitability level at a seasonally adjusted annual rate (SAAR) around 10 million vehicles. The US is currently on pace for SAAR of 16.2 million vehicles. To make GM profitable, unions were forced to take large pay cuts with GM shedding legacy healthcare and pension obligations while instituting competitive Tier I and Tier II price structures on its hourly and salaried workers. GM brought down labor costs to be almost in line with foreign manufacturers such as Toyota, Nissan, and Volkswagen. As the United Auto Workers union (UAW) lost some negotiation leverage with GM because of the bankruptcy, Ford was able to press the union for concessions as well. Consequently, this led GM and Ford to insource many sub assembly functions because they became cost competitive with outsourced firms like Automodular. Unsurprisingly, Ford decided to shift sub-assembly tasks in-house and Automodular was left with no work beyond 2014.

Considering the long lead time (over 12 months) for procuring new business in supply chain contracts involving sub-assembly and sequencing, and the fact that AM doesn’t have any contracts lined up, the most likely scenario is liquidation and return of shareholder assets in excess of liabilities. We are in May 2014 with eight months left until the end of Ford’s contract. Automodular will hold a special meeting on May 8th with a request for voter approval of a $19m equity capital reduction plan. The funds will be reallocated from the capital account into its contributed surplus account maintained for its common shares. Effectively, this is the way the management is starting to wind down the company while considering the tax implications of any funds distribution or share reduction.

VALUATION

Intrinsic value of the Automodular Corp workout incorporates four parts expanded below: adjusted assets, liabilities, new cash in 2014, and finally,valuation. I will not be applying a discount rate to this workout investment because it is going to be resolved in the next 9-12 months and a portion of my fund is set aside for workout situations to diversify from the vagaries of market fluctuations.

Adjusted assets with conservative multiples based on Benjamin Graham’s “Security Analysis” and liabilities can be seen on the balance sheet in table 1.

1. Adjusted assets with appropriate multiples upon liquidation.

a. Net operating losses of $8.2M applicable on profitable operations in the US are off balance sheet and will be completely written off under the assumption the company will not be able to utilize these NOLs.

2. Liabilities will need to be subtracted from adjusted assets to determine true book value.

a. $4.5m of operating lease commitments ranging 1-5 years out are assumed to be cancellable with a minimal 3-month penalty fee (based on my conversation with CEO Christopher Nutt, and company’s annual report). Current $3m of operating leases will be covered by operating expenses.

b. Pension plan securities will most likely convert into an annuity, causing excess costs of $500-$750k based on current discount rates according to Mr. Nutt, but this number is still undetermined.

TABLE 1

Assets				adjusted value	multiple
	cash	35,902		$ 35,902	1
trade and receivables		15,032		$ 12,026	0.8
prepaid expenses		1,719		$ 1,375	0.8
current assets			52,653

deferred income taxes		1088
investment
plant and equipment		4,426		$ 443	0.1
other assets		198
total assets			58,365	$ 49,745
Liabilities
payables & accrued liab		5,738
provisions		8942
income tax payable
current liabilities			14,680

deferred income taxes
provisions (more than 1 yr)		534
other liabilities
total liabilities			15,214	$ 15,214	1

shareholder equity			43,151	$ 34,531	liquidation

I am assuming that ~$3m of trade and receivables will not be realized at the end of the year due to some market disruption or non-payment. This is very conservative because the company may well receive the full amount and the disclosure in AM’s 2013 Annual Report indicates that trade and receivables are carried at fair value. I also wrote down plant and equipment to $443k, effectively realizing pennies on the dollar of original investment. This reduction is consistent with the depreciation schedule. Carrying value of PP&E assets on the balance sheet was aggressively written down by the management to reflect fair value and $33.5m has been depreciated to date. According to Christopher Nutt (CEO), supplier equipment is plentiful in Ontario and Automodular’s PP&E may not be worth much during wind down.

Note that provisions total about $9.5m on the balance sheet and any incremental costs relating to additional expenses running the plant during the contract extension from June to Dec 2014 will be covered by Ford. Technically, if provisions increase beyond $9.5m, every incremental dollar spent will also be allocated to the trade and receivables asset to compensate for that cost increase and the book value should be unaffected.

3. Change in cash position at the end of 2014 resulting from remaining operations.

a. Change in cash adds back dividends to reflect the projected cash generated in 2014, assuming the company keeps the same dividend payout from 2013. The company has not indicated a change in dividends so I’m keeping this number at status quo.

b. Change in cash adds back share repurchases similar to the level of 2013.

2014 Pro forma change in cash position reflects Operating Cash Flows (OCF) minus cash used in investing activities. New cash is not factored into the historical balance sheet numbers taken from the end of 2013. The key takeaway is the assumption that the change in cash will be accretive to shareholders either by flowing directly to the cash on the balance sheet (~$11m), dividends (~$6.7m), or share repurchases (~$1.5m), totaling ~$19m as in 2013. Any iteration of the above cash allocation in 2014 is acceptable as long as the cash generated by operating activities is similar to last year. Automodular is not projected to spend cash on investing activities because the company is not incurring CAPEX this year in anticipation of the wind down. Additionally, the change in cash should be consistent with last year’s production of ~$19m when we add back share repurchases and dividends because the scale/scope of work has not been significantly diminished. The salaried employees and hourly union employees benefit from staying until the end of the contract because they will receive a substantial severance bonus. This bonus is reflected in incremental costs paid by Ford and partly in current provisions of $9.5m. Provisions are a non-cash item that was capitalized (put on the balance sheet) in 2013 and include all exit costs associated with the wind down.

4. VALUATION factors in the adjusted assets, liabilities, change in cash positionat the end of the contract, and the 15% Canadian tax paid on foreign dividend distribution in excess of Paid-up Capital (PUC). A corporation can return PUC to shareholders tax free because it is treated as return of capital instead of dividends. Anything in excess of PUC will be treated as a dividend and will be taxed at 15%. So in the numbers below, I am estimating that the arbitrage amount will be taxed at 15% to arrive at the expected return number.

TABLE 2

CAN DOLLARS	Change in CF
	2014E	2013	2012
Financing activities
div paid	$ 6,712	$ 6,712	$ 8,880
shr repurch	$ 1,506	$ 1,506	$ 348
chng in cash	$ 10,941	$ 10,941	$ 10,185
total
new cash	$ 19,159	$ 19,159	$ 19,413
add:	VALUATION
liquidation val	$ 34,531
intrinsic value	$ 53,690
market cap	$ 41,660
arbitrage amt	$ 12,030
Canadian tax	15%
Expected return	$ 10,226
MOS %	24.5%
US DOLLARS	0.91	(exch rate USD to CAD)
2014 tot CF	$ 17,435
liquidation val	$ 31,424
intrinsic value	$ 48,858
AMZKF mkt cap	$ 37,911
arb amt	$ 10,948
Canadian tax	15%
Expected return	$ 9,306
MOS %	24.5%

Upside optionality

GM LITIGATION – the story is fascinating because Inteva (another supplier) won the business to sub-assemble Chevy Camaro parts from Automodular when General Motors (GM) put it up for bidding in 2010. Inteva, a non-union shop, was going to use a temp agency to fill jobs at $10-$12 per hour. AM, a unionized company, lost the business because it couldn’t compete on costs. The unions in Ontario got wind of what happened and were understandably upset. Inteva ended up hiring the same people that worked for AM, paying similar rates that AM would have paid. Automodular is taking Inteva and GM to court based on improper contract termination by GM and inducement of breach of contract by Inteva. AM is asking for a $25m restitution payout. AM’s contract was active during the first quarter of ’09 and in force until September ’10 when it was severed by GM. GM exited bankruptcy on July 10, 2009, and went public on November 18, 2010. I think AM will have a tough time extracting payment from GM in court because of the cloudy bankruptcy period and the potential New GM protection from Old GM. Perhaps Automodular may receive something in mediation due later this year because the contract was effective during the GM bankruptcy transition and the case isn’t clear cut on either side. If the case goes to court, the process will be dragged out for another year or two, undoubtedly increasing legal fees for all parties concerned. I give this upside optionality a value of $0, but it may be worth something if there is a mediation agreement or a court settlement.

Risks

– The overarching theme of Automodular CEO’s management style is enhancing shareholder value. The CEO stated that if the company does not procure a revenue stream within a reasonable amount of time, it will not sit idly in an attempt to find an inferior business to buy if the best course of action is to return cash to the shareholders. Considering the long lead time to generate a new supply contract, liquidation is the most likely scenario at this point. Obviously, if liquidation doesn’t take place because the company diversifies and buys another business instead of acquiring a new supply contract(s), then a discounted cash flow analysis would apply and the company valuation would increase appropriately. Liquidation is the floor scenario because management will only buy a business with higher intrinsic value than the wind down. However, an unwise acquisition is always a risk.

– Wind down may take longer than the projected time frame 9-12 months out from 5/1/14.

– The pension benefit plan may cost more than the projected $500-$750k to convert to an annuity. Given the current interest rate environment, annuities are more expensive than in higher interest rate times. The past CEO and his wife have a projected horizon of ~25 years.
– Salaried and hourly employees may leave prior to contract expiration at the end of the year and hinder operations causing a reduction in incoming cash this year.

Notes regarding the Defined Pension Benefit Plan

The Defined Pension Benefit Plan for the prior CEO calls for a total obligation of about $4.9m while the assets are $2.9m and liabilities are $2.8m for a total asset on the balance sheet of about $100k. When the company winds down, it will have to sell the securities that are generating payments for the pension and will need to purchase an annuity. That cost will fall between $2.9 and $4.9m and Christopher Nutt thinks it can be around $500-$750k in additional expenses; not material enough to factor in the analysis above.

Catalysts

– Share capital distribution should follow shortly after the Ford contract expiration in Dec 2014, when the company has no further revenue streams.

– $19m capital reduction plan up for vote on May 8th is a strong sign of management’s direction of thought toward winding down the company and returning the funds to the shareholders, consistent with the paid-up capital rules defined in the Canadian Tax Act. This step is orchestrated in line with prudent capital allocation and the desire to reduce taxes during the payout.

– An additional $3m should be released as part of trade/receivables fair value that I reduced to arrive at a really conservative number. If the $3m is released, expected return rises to 30.7% in less than 12 months assuming that change in cash is similar to 2013 and 2012. If the $3m is released and we stay with the target return rate of 25%, then the $3m can provide some cushion for the change in cash or some unexpected charges.

Summary

In this difficult sideways market, investment opportunities offering the most upside are going to include catalysts, dividends, and workout scenarios such as the wind down of Automodular Corporation. If the liquidation does not take place and the company continues as a going concern, it will do so because it received a new supply contract and valuation will be adjusted upwards because of the incremental cash flows. If the company buys another business, it will carry intrinsic value in excess of the wind down scenario. However, given the $19m capital reduction plan and the non-existent CAPEX, Automodular is heading towards a business wind down. Meanwhile, the stock pays a substantial dividend of over 10%. AM sports intrinsic value of $2.71-$2.86 CAN (if we take a multiple of .8 – 1.0 on trade receivables). That’s a margin of safety and expected return of 24.5%-30.7% on the current $2.15 CAN price within 9-12 months.