The first of my Venture ventures: ADF Group

One of my themes for 2014 is investments in the TSX Venture exchange.  I post the Venture performance every month when I compare it, along with the S&P 500 and the TSX, to my own performance. Since I started this blog, the Venture has been in a steady slide down and now is only a little more than half the value it was in 2011.

Now some of this move is of course due to an end (or lull if you so prefer) of the commodity boom, and many of the stocks associated with that boom aren’t coming back.  But I think there are also a number of names that have been dragged down with the ship, and that there are opportunities within small Canadian stocks that reside on the Venture.

So far I’ve got five names that I’ve taken a position in.  The company’s I am investing in are all quite small, so I am keeping my positions small and I’m not going to broadcast these posts all over twitter because my intent here is not to pump them as I think they will do just fine on their own merits.  In this post I am going to start with a discussion of ADF Group.

ADF Group (DRX)

ADF Group makes steel structures, heavy steel built-ups, as well as miscellaneous and architectural metalwork. They build steel products for high rises, commercial and recreational buildings, airport facilities, industrial complexes and nuclear facilities. They have a 600,000 sqft fabrication plant in Quebec and are in the process of ramping up a second 100,000 sqft plant in Montana.

The company has 32 million shares outstanding and a $25 million positive working capital balance, which puts the enterprise value at somewhere around $75 million. I bought the stock starting at $2.80 all the way up to $3.

The third quarter was a breakout quarter for the company. They did $6.8 million of EBITDA in Q3, versus $9.8 million for the first 9 months of the year. The backlog looks solid and is up to $55 million from $34 million at the beginning of the year. The current results are not reflecting the Montana plant, which will only start-up in Q1. The company said they were quite positive on new orders in Western Canada, from which the Montana facility should benefit.

ADF Group also stands to benefit from the falling Canadian dollar. The dollar is nearly 10% lower than last year, which makes the company more competitive for US projects. While I wasn’t able to find a revenue breakdown between Canada and the United States, they mention in MD&A that “generally, there are more complex steel structure projects in the United States than in Canada, which could result in a certain dependence of the Corporation on the U.S. market.”

The stock is not without risk. Its clearly levered to growth in North America. And the company gave a fairly lukewarm outlook for its Eastern business in the third quarter, saying:

Although ADF’s current main markets have been showing signs of recovery in recent months, prices remain very low due to an excess of production over demand. In Management’s opinion, this imbalance will persist in the coming months

Also of concern, a comparison of the company’s historical results to its third quarter shows that it was quite a bit above trend. I went back and looked through the income statements since 2005 and I never saw revenue at the level that it was in Q3. So a bet on the company at this level has to be made on the expectation that the company can maintain a level of business higher than it has been able to do in the past.

The increase in revenue in the third quarter was helped by construction contracts for two Quebec Amphitheatres. These contracts totaled $47 million, a bid that was seen to be too low at the time but that seems to be generating decent margins thus far.

While the amphitheatre revenue will taper off after the fourth quarter, the company will see the benefit of the new Montana fabrication plant. The Montana plant is the big catalyst for the stock. Based on a square footage comparison to the Quebec facility, one would only expect that the Montana plant would provide some incremental work, but after digging into it a bit I think the step change could be more significant. Taken from this article, the company says that “at full production, the western base could ramp up to about US$100 million in annual revenues, compared to peak Terrebonne revenues of $150 million to $200 million, Paschini said.”

While the Terrebonne facility has a theoretical capacity of $150 million to $200 million, I did not see annual revenues exceeding $100 million. So if we are to assume the Montana facility can run close to capacity once fully operational, which is something that does not seem out of the question given its location close to the Bakken, close to the Alberta oil sands, and close to British Columbia LNG export projects (indeed the company strategically chose the location in Grand Falls in order to be close to these end markets), we are looking at a doubling of revenues off of the current base.

The story here is a company that is obviously quite leveraged to an improving economy. As we finally begin to outgrow our excess capacity and require new structures to be built, ADF Group is in a prime business to benefit. You are not overpaying for this leverage; at the current price, which is somewhat higher than I paid, they still trade at only a little more than 3x EV/EBITDA based on Q3 earnings (though admittedly a much higher multiple if you look further back to Q1 and Q2 results). If compare them to Canam, a close competitor (they also bid on the amphitheatre), which trades at over 6x EV/EBITDA, ADF Group stacks up well.

As with the other TSX Venture stocks that I am looking at, I have to be careful about sizing the position so that I can easily get out if need be. The company only trades about 30,000 shares per day so I don’t want to get trapped. For now I took a small position (1.5%), to which I will add if there is further clarity on the order backlog for 2014, but probably not let it get above the 2% level.