In yet another example of “loaning money to Canadians or Canadian companies isn’t a real business and making money that way doesn’t count”, we have Callidus Capital. Now, to be fair, this is how Callidus explains their business:
Callidus Capital Corporation is a Canadian company that specializes in innovative and creative financing solutions for companies that are unable to obtain adequate financing from conventional lending institutions. Unlike conventional lending institutions who demand a long list of covenants and make credit decisions based on cash flow and projections, Callidus credit facilities have few, if any, covenants and are based on the value of the borrower’s assets, its enterprise value and borrowing needs.
It is tough to read that and not immediately think “We loan to oil and gas companies in the middle of Fort McMurray with no regard to how much money they make. All we care about is that they own some land and they have a need to borrow money”. But since their IPO, Callidus has proven there’s a market for their financing. And at the moment Callidus is pretty cheap, and have a catalyst on the horizon for which I don’t think the stock is getting enough credit.
Let’s start with the traditional metrics of valuation. Callidus is trading at 14.3x P/E. The closest they have to peers would be Chesswood Group (17.4x) or ECN Capital (15.4x). They trade at 1.9x P/B.
But those cheap numbers come with a caveat ass well. Something called yield enhancements. When Callidus makes a loan, they negotiate returns over and above the interest rate of the loan. Callidus often acquires warrants or options in the companies to which they loan. In the 2016 Q3 earnings release COO David Reese said the following about the yield enhancements:
We also added $23.1 million in yield enhancements which will contribute to future earnings, an increase of 40% in one quarter. Failing to recognize yield enhancements booked, runs the risk of transferring value from current to future shareholders, due to technical and timing issues. This quarter’s recognition of yield enhancements demonstrates it is a fundamental part of the business, just like provisions are, they are basically the opposite sides of the same restructuring coin, but can result in significant mismatching of timing in income recognition.
So they acquired warrants/options/derivatives of $23.1 million in the quarter, adding significant value to the company, but it’s tough to predict when these yield enhancements will provide earnings to benefit shareholders. I think these yield enhancements are misunderstood (possibly a failing on the company’s part). Yield enhancements on the balance sheet are internally valued at $80.6 million, and after 9 months in 2016 had contributed $38.1 million of income. But accounting rules dictate when these incomes can be realized, hence the COO’s fear that the value the company is adding now may only benefit future shareholders (since the market is discounting the yield enhancements now).
After that long aside, let’s continue with the valuation and what management has been doing. Through the first 9 months of 2016, Callidus had a return on equity (ROE) of 17.5%, an improvement over the same period in 2015, and an admirable number. ROE can be “gamed” by adding debt, but Callidus actually decreased their leverage from 2015 to 2016, and are operating with a leverage ratio of 40.3% (down from 52.8%). Debt decreased by $69 million in the 9 months ended September 30, 2016.
Speaking of debt pay down, let’s talk about the shareholder yield of Callidus.
Shareholder yield can be defined as all the money used by the company to directly benefit shareholders. This excellent Meb Faber podcast goes in depth on the subject. Most people will look at the dividend yield of a stock. But share buybacks also benefit shareholders, by increasing their stake in the company. Paying down debt doesn’t always get included, but paying down debt definitely benefits the shareholders, so we’ll include it here.
So Callidus paid down $69 million of debt in 9 months. Let’s be conservative and assume they didn’t pay down any debt in Q4, since we do not have the numbers. Callidus had 49,354,355 shares (fully diluted) outstanding at the start of 2016. This means they paid down $1.40 of debt per share, at current prices that’s a “debt payment yield”, yes I think I made that up, of 7.4%.
Callidus also right now has a dividend yield, which I did not make up, of 6.33%. They payout $1.20 as a dividend. This has been initiated and increased by management in a desperate effort to get the market to realize the value of the company. This Bloomberg article goes into the various ways the CEO has tried to fight off short sellers and increase the stock price.
The last component of shareholder yield is share buybacks. Callidus had a substantial issuer bid in place during 2016. Under this SIB they purchased and cancelled 2,849,604 shares, all of which bought at $16.50/share. This means they used another $0.95/share to benefit shareholders, a buyback yield of 5%. Callidus recently annouced that they have a normal course issuer bid in place now as well, meaning they are likely to continue buying back shares. They view shares as very undervalued, which I agree with, so this is a prudent use of more capital.
The total shareholder yield of Callidus is 18.7%. In 2016, Callidus returned almost one fifth of their current share price to shareholders. If I had to guess, I’d say that this shareholder friendly use of capital is at least part of the reason the stock has doubled in the past year.
Now for the catalyst that is being rewarded, but probably not as much as it should be. Privatization.
In that Bloomberg link further up, you’ll read that one of the levers management is pulling to realize value is looking into taking the company private. On September 30, 2016, Callidus announced they were going to look for advisors for the process of privatizing. On Halloween they announced that they had appointed Goldman Sachs as the advisor for this process, and that they expected the process to be complete by the end of Q2 2017. Valentine’s day they announced that they had signed 17 companies to NDA’s, and that the process was still on schedule to be done by the end of Q2.
Callidus is far down the road of going private, and they seem fully committed to it. In April 2016 they publicized that they had received a formal valuation from National Bank that estimated the fair value of shares was between $18 and $22. And since then almost all financial stocks have rallied, so I’d have to guess that the fair value has increased as well. CEO Newton Glassman has a great name, and suggests the company should be valued at 1.8x the loan book. The loan book has grown since the article in that link, and 1.8x the outstanding loans would be over $43/share. That is unlikely considering where shares trade now, around $19.
I truly believe that management is engaged in the privatization talks to maximize shareholder value. Glassman’s private equity fund Catalyst Capital Group, and various funds offered by Catalyst, own 67% of Callidus. It would have been very easy for Catalyst to offer to take Callidus private alone at $16.50 (shares traded under $10 in early 2016). They could have offered $20 and took the company private. But Catalyst has insisted on taking Callidus private with a partner. This benefits them by valuing their shares higher, but also will benefit all shareholders, by maximizing what us peasant shareholders will get for our shares. Their motives of course are not purely altruistic, but they seem to be working in the best interest of shareholders. Glassman if anything has proven himself willing to fight for Callidus to be valued fairly.
Fair value is somewhere between $19 and $43.85 though. Even if Callidus got valued at 1x the loan book, that would be $24.36. A 1x valuation of the loan book seems very low, but it would still serve as a 28% premium to Friday’s close. The deal is still expected to close by the end of June, so buying shares now would offer an annualized return somewhere around 100% at a buyout price of $24.36.
Since an annualized return of 100% seems too good to be true, let’s go with a worst case scenario of only receiving $20/share as an offer. Annualized this return would still be over 15%.
Risk of Deal Falling Through
There obviously is the risk that nothing comes of these discussions to take the company private, or they are at least delayed past the expected Q2 close. This would likely lead to a collapse of the share price, since at least some holders are counting on this privatization. But there’s no reason to believe management would cease the process of taking the company private. It would simply extend the thesis out a year or however long it would take.
Then again, you could be left with a company growing its loans outstanding, has a 6% dividend (at these prices, so it could be even higher if shares plummet) which is well covered, has “hidden” value in the form of the yield enhancements, and a management team that is hellbent on maximizing value for shareholders. There are worse things to hold.
All of those good things said – in the interest of giving you the full picture – Callidus is currently involved in several lawsuits, claiming they preyed on companies who didn’t fully understand the terms of their financing. Callidus has sued back, and say they have precedent from other cases saying a positive outcome is likely. I don’t view these as that serious, but I am definitely not a lawyer.
Let’s wrap this thing up.
Callidus Capital is a growing distressed lender, an industry that hasn’t been getting much love in Canada. They currently trade at a cheap valuation, with a 6+% dividend. They are trying to be taken private before the second quarter ends, which if it’s successful should provide a return of at least 15% annualized and a visible end game. But if the catalyst doesn’t come to be, you’ll hold a cheap, growing company making tonnes of money and sharing that money with you by buying back shares and paying a generous dividend.
Disclosure: I have no position in Callidus Capital, but intend to purchase a shares within 72 hours.