Mainstreet Equity Corp – A Better Way to Buy Apartments

At one time it could have been argued that my portfolio was light on financial companies. In light of the make up of the Canadian market, I don’t necessarily see this as a bad thing.

Fortunately, I’ve been finding a lot of value in financial names since started writing here. I was introduced to Integrated Asset Management. IAM is now consistently trading around $1.48, offering a 5.4% yield and buying back shares while I wait for better operating leverage. I bought into E-L Financial, trading at a 38% discount to book value and producing very good earnings. I would be happy to add more since the stock has not moved after reporting its year end results. With the uncertainty of the proposed GGP deal, I’m once again seeing a lot of value in BPY.UN. I think Fairfax Financial is trading below intrinsic value.

The problem is, while I do not want to make any market calls, I am hesitant to overweight financials/real estate. But financials, real estate, and commoditites are where I’m seeing value. In that vein, a friend of the blog recently implored me to look at Mainstreet Equity Corp (MEQ). After a very quick look I liked what I saw.

mainstreet equity corp
Source: https://mainst.biz/

Background

Mainstreet Equity Corp was started by Bob Dhillon, and I have no problem admitting a lot of what I like about Mainstreet is him. I’m a sucker for a success story like his, and I love to align myself with a CEO who has created so much value for shareholders even if I’m a bit late to the party. Since going public in 1998, Mainstreet has grown from 272 rental units to over 11,000 while keeping the share count static. The market value of its portfolio has increased 100x in 20  years.  There are plenty of interviews with Mr. Dhillon out there, so it’s easy to see he certainly talks the talk of a great capital allocator.

mainstreet equity stock
Source: TMXMoney

This is how Mainstreet describes its business:

Mainstreet positions itself as a value creator by purchasing under-performing properties, renovating them to a branded standard, improving operating efficiencies and repositioning them in the market for greater returns. Mainstreet currently owns and operates properties in Surrey, BC; New Westminster, BC; Abbotsford, BC; Calgary, AB; Cochrane, AB; Edmonton, AB; Lethbridge, AB; Fort Saskatchewan, AB; Regina, SK; and Saskatoon, SK.

The model obviously works. Buy downtrodden buildings, renovate them a bit, lower operating costs, then raise rents. Mainstreet minimizes competition by being in markets where the cost of buying properties is lower than the cost of building new ones, and by buying buildings too big for small investors but too small for large REITs. There is also a lot of rental demand in the cities where Mainstreet operates as rental units are in short supply.

This slide is in the latest investor presentation as an example of how Mainstreet improves profitability of its units while also improving the environment for the tenants.

mainstreet park edmonton
Source: Mainstreet Q1 Investor Presentation

Shares Outstanding

For the purpose of my valuation, I will consider all options as shares. All of the options are very much in the money (exercisable at $5.51) so as far as I’m concerned they are equal to a share at this point. The shares outstanding number I’ll be using is 9,660,505. If you want to see it broken out, there are 828,200 options outstanding and exercisable.

It’s also noteworthy that the company recently announced the board had approved a new stock option plan, but:

Based on feedback received from certain institutional shareholders, the Mainstreet Board has made a determination to revoke its approval of the 2018 Plan and defer the matter for re-consideration at some time in the future.

The current option plan does not allow options to be granted after March 24, 2017. The new plan would have allowed 1,760,000 options to be issued, representing 19.9% of shares outstanding. I can only speculate what these shareholders disliked about the plan, but I certainly appreciate them voicing their concern. One of the most reasonable ways to value Mainstreet is on NAV per share, so anything that reduces shares outstanding is a good thing. I’m probably more opposed to options than most people though.

Insider Ownership

Mr. Dhillon owns 39.5% of the company. Insiders besides him own another 2.8%.

Today’s Valuation

In the twelve months ending December 31 2017 (Mainstreet’s fiscal year ends September 3oth), Mainstreet had funds from operations (FFO) of $2.88 per share, so MEQ is trading at 13.9x FFO. That’s not fantastic objectively, but it’s pretty good compared to its peers. Here are what the other apartment REITs in Canada trade at:

  • Boardwalk – 21x
  • CAPREIT – 20.6x
  • InterRent – 23.9x
  • Killam Apartment – 15.4x
  • Morguard North American Residential – 11.5x
  • Northview Apartment – 12.4x

These aren’t apples to apples comparisons, but if it’s unfair it is unfair to Mainstreet. I did not look at the capital structures of these peers to see if there were options/debentures/etc to add to the share count. You can see that Mainstreet is trading at a reasonable, borderline attractive multiple of FFO even after weighing down its per share numbers.

I also see that I need to look closer at MRG.UN and NVU.UN. All I’ve done is look at FFO multiples but they look cheap so far.

The valuation of Mainstreet gets more interesting when we look at net asset value. Before we get to that though, here are the cap rates Mainstreet has used to value its properties:

  • Surrey, BC – 4.05%
  • Abbotsford, BC – 4.70%
  • Calgary, AB – 4.84%
  • Edmonton, AB – 5.74%
  • Regina, SK – 5.95%
  • Saskatoon, SK – 6.67%
  • Total – 5.22%

I’ll let you decide if you think those are fair. As a point of reference, Boardwalk values their properties using an average 5.29% cap rate, so I don’t think this estimate is completely out to lunch. Using a cap rate of 5.22% on its investment properties, the net asset value of Mainstreet is $82.91 per share. If we take that as accurate, shares are trading at a 51% discount to book value (using 5.29% Boardwalk trades at a 27% discount to NAV). My NAV number is different than the number on the slide below since I accounted for options.

mainstreet equity assets
Source: Mainstreet Equity Q1 Investor Presentaion

Even if I use 5.97% as the cap rate, and including $134 million of non-mortgage liabilities, I calculate net asset value to be $44.82. Mainstreet is trading at a 10.5% discount to this.

Full disclosure, I haven’t looked at the peers to see if a discount to NAV is endemic to the apartment sector. The reason is partly laziness, I can’t just look at the unit price and last news release since some of the REITs don’t put the NAV in them. But the bigger reason is it doesn’t matter to me whether all apartment operators trade below their NAV or not. For what it’s worth though, this InterRent presentation suggests that trading anywhere from 90%-100% of NAV is typical.

apartment reits
Source: InterRent Investor Presentation

If for some reason you don’t like my NAV calculation, the “consensus” NAV for Mainstreet is $47.74.

I don’t want to speak to the accuracy of these NAV numbers, as they are based on consensus estimates for which I do not know the inputs. But if we use my conservative estimate for Mainstreet and take these numbers at face value, Mainstreet still compares favourably. Since Morguard is the cheapest on the above chart, I looked to make sure using 5.97% as my cap rate is conservative, and MRG.UN values its properties using a weighted average cap rate of 4.9%. These are higher quality buildings and geographies than Mainstreet’s (best as I can tell), but it made me comfortable I was being fair with my cap rate.

Based on today’s valuation, and comparisons with its peers, I would say that Mainstreet is attractively priced.

I’d also note that anyone reading this ought to look at some of the other apartment REITs. I only ever really paid attention to CAPREIT, which I always thought was overvalued. I’m adding MRG.UN, NVU.UN to my watchlist. Turns out there could be some value in the sector yet!

Operational Improvements

While Mainstreet Equity is probably underpriced today, what makes today’s price attractive is how much the business can/will be improved in the future.

Remember that Mainstreet’s model is to buy underperforming buildings, renovate them, and raise rents. Management differentiates buildings they consider “stabilized” versus those that they are in the process of improving. Today, 11.6% of the portfolio is in the process of “stabilization”. Below is the property portfolio broken out:

mainstreet equity properties
Source: Mainstreet Q1 Report

If you go up and look at the case study of a building in Edmonton and this table, it’s easy to see the stabilization process adds a lot of value to Mainstreet. The unstabilized units in Edmonton for instance have a 45% vacancy rate! Just getting those 318 units to a 25% vacancy rate at their current rent results in over $900,000 in revenue.

I ignore the last column. Mainstreet defines optimum conditions as a 5% vacancy rate and charging market rent, which is probably unrealistic and definitely shouldn’t be used for an investment thesis. But if in 2 years the unstabilized portfolio can perform similarly to the stabilized (9% vacancy, 90% of market rent), revenue would increase over $4 million, or 4% absent any other improvements or acquisitions.

Even the properties classified as stabilized have the potential to be better utilized.  As can be seen below, in Mainstreet’s two largest markets by units owned, vacancy rates are above average.

boardwalk reit alberta rent
Source: Boardwalk Investor Presentation

2018

Dhillon states that the focus for 2018 is on buying back shares and stabilizing the portfolio. As luck would have it, these the two best uses of Mainstreet’s capital right now. It is estimated the company has roughly $150 million of liquidity, and it is also working to finance buildings without mortgages to lock in low interest rates and increasing liquidity. There is plenty of money to buyback shares, fix up the portfolio, and acquire new buildings if the opportunity arises.

In spite of the proposed and then cancelled option plan, Mainstreet prides itself on its share count. Dhillon has boasted about growing the company so much without issuing shares, and it is mentioned on the company website in several places. It is just a hunch of mine, but I predict shares will be bought back such that options being exercised does not increase the share count at all. MEQ does not pay a dividend, but I expect significant capital will be returned to shareholders via buybacks.

As for how stabilization will increase FFO, I don’t want to guess. I don’t want my glasses to be any more rose coloured than the 4%over two years number I hinted at above. I’m pretty sure there is upside I’m not accounting for though.

By annualizing Q1’s results, I calculate full year 2018 FFO will be $2.93, up 1.7% year over year. I’ll predict stabilization increases rental revenue $750,000 at a 30% FFO margin, and that Mainstreet buys back 2% of shares outstanding. I think a 15x FFO multiple is fair when you consider stabilization will have improved the portfolio, so Mainstreet should be trading at $45 on September 30th. Upside of 12.5% over the course of six months isn’t bad but I’m also not writing home about it.

Slumlord?

Mainstreet apartments appear to have a bad reputation. I did not look hard, but found an entire (very small) blog dedicated to Mainstreet sucking, with some horror stories in the comments. I also found this Reddit thread, and this one. I really can’t say whether these criticisms are fair, but there is definitely a reputation risk with Mainstreet. If potential tenants ask online or search for reviews; and get answers like these or read these same stories, I figure it has to have an impact on vacancy rates and the rent that can be charged. People can’t complain about bed bugs, mould, and huge rent hikes without hurting the bottom line a little bit.

To his credit, Dhillon knows about the problem:

One of the negative comments we get is that ‘You guys are slum landlords,’” Dhillon says. “But what they don’t understand is that we buy slum properties and transform them. Per capita, we’ve spent more money on [capital expenditures] than anyone else. They see the old – they don’t see the new. And there’s always a lot of old coming through the pipe, so they stereotype all these buildings.

The perception is probably a bit right and a bit wrong. Mainstreet buildings likely do have pest problems, the whole business model is buying neglected buildings with problems. And even after renovating some units, issues will persist for some time until the whole building can be brought up to standards. Tenants do have clouded vision though. Any rent increase will be viewed as an affront. Any pest or maintenance issue at all will be the biggest deal in the world to a tenant. And internet reviews will always skew negative. If anybody has personal experience with a Mainstreet building I’d love to hear it, but as it stands I don’t think there’s any ethical concerns here.

Conclusion

Mainstreet Equity Corp is cheap when compared to its peers, and the business model comes with a few levers that I think will be pulled in the near future to increase FFO. Apartments are in style right now, they’re seen as a way to play the expensive Canadian housing story (“Canadians can’t afford houses, bet they’ll rent!”). But Mainstreet has not seen the multiple expansion that most of the sector has. The reasons the market is discounting it – the locations, the high vacancy rates, low rents, crummy buildings, etc – are the exact reasons that I think Mainstreet will be rerated going forward. Management has shown that they can execute their business model, which is fixing the vacancy rates, low rents, and crummy buildings.

Personally I’d much rather own Mainstreet a 11% vacancy rate, than any of the other guys at 3%-5% vacancies. Good things happen when occupancy and ROE increase, and at Mainstreet there’s a much greater chance of occupancy going up than down.

If you read enough about Bob Dhillon, you will see the term counter cyclical quite a bit. The past couple years Mainstreet has bought a lot of properties when nobody else wanted to. The next couple years these investments should start paying off. Above I predicted the share price should increase $5 over the next six months, a solid but not exciting return. Buying Mainstreet is not a six month decision however. I don’t want to buy Mainstreet because the share price will be $45 in October 2018, I want to buy it because the share price will be $85 in October 2021. This is a wonderful business trading slightly below its fair price.

Disclosure – No position in MEQ yet. Might initiate a position this week.

Evergreen Gaming

I’ve been meaning to really look at Evergreen Gaming for a while. It looked cheap enough superficially, but between a few other opportunities, and the gradual deleveraging I’ve been trying to do, I hadn’t felt the need to do a very deep dive on Evergreen (TNA).

But a reader asked me about it, and it snowed approximately a foot here last weekend, so I had some time and finally got around to looking closer.

Overview

Evergreen Gaming Corporation operates four casinos in Washington state. The casinos seem to only offer card tables and pull-tabs, which appear to be the same thing as the lottery tickets of the same name. So the casinos can’t quite be compared apples to apples with casinos which have slot machines.

Financials

Evergreen is quite profitable. Through nine months of 2017, Evergreen had earnings of $2 million. Annualized, these results would equal about 2.1 cents per share, meaning Evergreen is trading at just 8x P/E. Both revenue and earnings are up year over year, despite having shut down a casino in February 2017.

Palace Tukwila

The company just recently completed the sale of a full casino, The Palace Tukwila, which was realized to be either unprofitable or untenable in some way. According to the Q3 MD&A:

The Company did operate a fifth casino, the Palace Casino in Tukwila, but that property was closed on February 4, 2017. The Company has entered into an agreement to sell the real property where Palace Tukwila was located for $1,950,000. The buyer has made a $50,000 earnest money deposit and the sale is supposed to close on or before November 30, 2017.

The property was sold for almost $900,000 more than the mortgage balance and $515,816 over its value on the balance sheet. This indicates to me that we can consider the rest of the balance sheet conservative.

Excluding goodwill completely (not necessarily fair, but works as a margin of safety) and including the Tukwila sale, book value is $0.08 per share. On book value then it doesn’t look cheap. But there’s almost $0.06 of unrestricted cash on the balance sheet (there is also restricted cash, which is held in case of a large jackpot).

It’s clear to me that there’s no business reason to be holding this much cash, so it ought to be returned to shareholders in some way. If this guy is to be believed, the chairman’s preference is paying down debt with the possibility of a share buyback in the future. The debt is low interest, with a favourable maturity schedule, so my preference would be the buyback.

Future?

I really can’t claim to have any idea of the future prospects of Evergreen, there’s a few balls up in the air and I don’t have a firm grasp in what direction the company will be steered.

As an example of “balls up in the air”, Washington is in the process of increasing its minimum wage significantly in the next few years. The company issued a prediction of how it will affect profitability:

The present minimum wage increased from $9.47 in 2016 to $11.00 in January 2017, and in future years
the wage increases to $11.50 in 2018, $12.00 in 2019 and $13.50/hour in the year 2020. The increases
to the minimum wage will also impact hourly wage rates for employees with greater experience and
responsibility. The cumulative effect on wages, including payroll taxes over the four year period is
projected to be $1,394,000, $2,041,000, $2,690,000, and $4,327,000 respectively.

This is obviously a large hit to a company with less than $3 million of earnings. The good news is that in 2017 the increased earnings already reflect the increased labour costs. It’s more of an economic debate whether the increased minimum wage will lead to higher revenues. For the time being, the company has managed to navigate this hurdle, but it’s an undesirable headwind.

A tailwind that will partly offset the wage hikes will be the corporate tax cut implemented in the US. Through nine months of 2017, the company had set aside 35% of earnings, over $1 million, for income tax. In 2018 the company stands to save ~$400,000 in taxes.

Those don’t quite balance out (the business earns less than if neither happened).  Another thing that has me hesitant on Evergreen is the end game. There are a few paths forward from here that I can see.

Growth

I’m not sure how likely Evergreen pursuing a growth strategy is. Dawn Mangano has been the CEO since June, and she has grown a chain of casinos in the past. I also can’t make any guesses at the growth prospects, how many small casinos are available to be acquired or built, or how profitable they would be. For significant market expansion though, this is the path Evergreen will need to take. I don’t want to pretend I know what this growth would look like, or how it would affect the target price of Evergreen, so I’ll just ignore the possibility. Keep in mind that Mangano, may choose to grow the business, and that could offer significant upside.

Buyout

Insiders own 78% of the stock and I believe the most likely end game for Evergreen is a buyout so the insiders can get their liquidity event. If I were going to buy into Evergreen, it would be in the hope of Evergreen being taken over.

For a rough guess at a buyout multiple, let’s say Evergreen can improve earnings to $3 million annually, which should be close to $4 million EBITDA. I’ll also assume that half of the debt is paid down, and there’s $6 million net cash on the balance sheet. For a sleepy little company like this, I would consider 10x EV/EBITDA to be a fair multiple. A buyout under these circumstances would come to $0.34, 100% upside to today’s price. While the stars look aligned for a buyout offer to come, I don’t want to invest/speculate on it.

Steady As She Goes

There’s also the possibility that Evergreen continues business as usual. I believe the new leadership can extract a lot of value in the short term, hence my prediction that $3 million in earnings isn’t that far down the road. But without any new levers to pull, the growth is capped at a certain point. I’m not sure that Evergreen deserves much more than a 10x P/E multiple once growth slows down; n two years, earning $3 million and growing 5% per year, this would equate to a $0.24 target price.

Conclusion

If I were just looking to buy a basket of undervalued stocks, Evergreen would certainly be in the basket. I’m tempted to buy TNA, as I see the downside as very low. I imagine the customers are pretty sticky, and with the current valuation I’m not sure the share price can reasonably go down much. But I also don’t believe that just because a stock is cheap compared to other stocks that the share price deserves to increase. Evergreen’s business should command a below market multiple, in the absence of any changes (growth strategy, dividend/share buyback, etc). Maybe in today’s market that could be a 12x P/E, indicating more upside, but the margin of safety isn’t enough for me. If I had to bet on the most likely return for shareholders going forward, it would be 5%-10% if a buyout doesn’t happen. I’ll be keeping my eye on TNA, as I have been for a while. I’d probably jump all over it at $0.12, and would maybe start a small position at $0.15.

Disclosure: No position in Evergreen Gaming (TNA)

Ergoresearch Going Private at $0.30

The news comes as bitter sweet. Ergoresearch is being taken private for just a 20% premium over my purchase price.

When I first bought ERG, I expected so much more. The company had discontinued an unprofitable line of business, which made revenue look bad but improved free cash flow. Ergoresearch was also starting up new clinics, moving into sleep apnea treatments, and had at least mentioned returning to its acquisitive ways. The bitter part of the deal is because my investment in Ergoresearch could have been so much more.

Then the company sort of went dark. One day I noticed that I hadn’t seen a news release about earnings, so I went looking and found that there wasn’t a press release, the financial statements were simply put on SEDAR. And the numbers were only put on SEDAR in French. I thought this was a little curious, it was a bit annoying but thought it may provide value investors more opportunity to buy while ERG was unfound.

Then this news of the privatization came out not long after. The sweet part is that Ergoresearch shares were unlikely to move higher anytime soon. By not announcing earnings, and by only releasing numbers in French, it effectively hides the company from a large percentage of the investment community. I’m fully aware that the business is improving, and this is an excellent deal for Sylvain Boucher and Walter Capital. They are acquiring a business with growing free cash flow and exciting initiatives that should grow the business in the future. For small shareholders like me, we’re provided an out for our shares that were probably still going to be in the $0.20-$0.25 range for  year or more.

I’m mildly disappointed in this investment. I think the prospects of ERG deserve a higher premium, but I doubt anyone who has been holding their shares is patient enough to demand it or want to keep the company public. I sold my share at $0.295 and have moved on.

 

Integrated Asset Management – Follow Up

Nine months ago I wrote my thesis on Integrated Asset Management, which I thought should be trading at $1.49 on September 30th (end of fiscal 2017). I’m not usually anywhere close to this right, but IAM was $1.54 on September 29th.

Since then however, IAM has traded down to its current $1.38. I made a number of assumptions coming to my 2017 target, as well as my 2018 target of $1.76, with the share price lingering I decided I ought to take another look at these assumptions and make some new targets. Continue reading “Integrated Asset Management – Follow Up”

Spectra Inc.

Trucking is pretty damn dangerous. Anyone in Ontario will likely recall this accident, which killed three and closed the 400 highway southbound lane for over a day. Some of you reading this may have heard of Operation Air Brake, which involve “blitzes” of commercial vehicle inspections, and always ends up taking hundreds or thousands of trucks off the road for brake related violations.

In Toronto, there is a small (and I mean small) company making products that would help prevent many of these violations, which means the truck keeps rolling, the freight gets where it’s going, etc. The value proposition is pretty clear for Spectra Inc.

Luckily for me, Spectra offers an excellent investment opportunity.

spectra inc ssa
Source: http://www.spectraproducts.ca/

Continue reading “Spectra Inc.”

Atlas Engineered Products – Getting in on the Ground Floor

There is not much to read out there about Atlas Engineered Products. The company doesn’t even have a website (EDIT – now there is a website). But in that lack of information lies an opportunity for investors to get in on the ground floor of what should be a very successful capital compounding story.

atlas engineered products
Source: atlasengineeredproducts.com

Continue reading “Atlas Engineered Products – Getting in on the Ground Floor”

Portfolio Update – December 2017

It’s been a long time since I’ve gotten on here to write about my stocks. No real excuses, just prioritized some other things. I’m sure nobody was really calling the police wondering what happened to me, so I’ll just jump right into this. Let’s start with one where I was very wrong. Continue reading “Portfolio Update – December 2017”

Ergoresearch Ltd. – Another Diamond in the Quebec Rough

If you have been so kind as to have read some of what I’ve written on this blog, you may remember that I had a chance to invest in a Quebec microcap trading at just two times earnings. Alas, for reasons I either can’t or don’t want to remember, I passed on buying PCI. If I had bought when I originally found the company, I’d be looking at almost a 300% return in under a year. If I had bought it when I had wrote about missing the opportunity, I’d still be looking at over a double.

I don’t intend to make the same mistake again.  Continue reading “Ergoresearch Ltd. – Another Diamond in the Quebec Rough”