Terra Nova Royalty Still Owns 3% of KHD Humboldt Wedag

Includes: KHDHF, MFCB
by: Clemens Scholl

All during last year (2010), the company now operating under the name “Terra Nova Royalty Corporation” (NYSEARCA:TTT) was in heavy restructuring. This involved the spin-off, in several tranches, of shares of in the cement plant engineering business KHD Humboldt Wedag International AG (KHDHF.PK) (see previous article).

However, it seems Terra Nova is not completely cutting its ties to KHD, as I will show.

At the beginning of 2010, TTT owned 32,360,828 shares of KHD, representing a 97.6% ownership of the company (see KHD listing prospectus, p. 148). The remaining shares were in free float and traded on the
Frankfurt exchange in Germany.

During 2010, KHD shares were distributed in three tranches:

First tranche

8,645,688 shares distributed

1 KHD for 3.5 TTT

Second tranche

7,571,228 shares distributed

1 KHD for 4 TTT*

Third tranche

9,474,384 shares distributed

1 KHD for 4 TTT**

Click to enlarge

* this distribution was subject to a 15% Canadian withholding tax

** the number of TTT shares was higher at the moment of the third distribution because TTT conducted a capital increase via rights offering between the second and third distribution, thus the total amount of KHD shares distributed was also higher

In total, TTT distributed 25,691,300 KHD shares in the first three distributions to all of its shareholders according to its SEC filings and quarterly reports.

After the amalgamation with Mass Financial (OTC:MFCAF), TTT carried out a fourth and last distribution of KHD shares on a basis of 1 KHD share for 10 TTT shares held. As the amount of TTT shares has nearly doubled, (62,570,388 shares outstanding) another 6,257,039 KHD shares will be distributed to all Terra Nova shareholders on record at December 31, 2010. The total amount distributed to all shareholders of the company would thus be 31,948,339 shares, leaving 412,489 shares with Terra Nova.

However, this is not completely true. During the third quarter, Terra Nova repurchased and cancelled 2,174,988 of its own shares (at an average cost of $8.45, thus before the distribution). It seems that before they were cancelled, these shares also received their proportionate share of the third KHD distribution, 543,747 shares.

Distributed or not ?

If Terra Nova retained 543,747 extra KHD shares, that would mean only 25,691,300 - 543,747 = 25,147,553 shares would have effectively been distributed to shareholders other than Terra Nova itself.

There is proof for this theory. On December 29, KHD released the prospectus for its proposed rights issue that will start next week. For legal reasons, I will not quote from the prospectus, since it should not be made available to persons that are not resident in the Federal Republic of Germany. The prospectus is available on the KHD website, here. The prospectus confirms that only 25.1m shares were distributed by Terra Nova to shareholders. This mention in the prospectus was what first made me wonder; as it did not coincide with the number I had in mind for the distributed KHD shares. So what I have written here is actually the reverse process of what I went through, but it is of course much clearer the other way around.

Why does it matter ?

All the above indicates that after the fourth distribution of KHD shares, Terra Nova still owns about 990k shares of KHD, amounting to 2.99% of KHD’s outstanding shares. Surprise, surprise – the legal notification threshold for large shareholdings is 3%. So Terra Nova would be just a few shares below that threshold.

But that’s not that important, other than being another testament to the “stealth fighter” operating philosophy at Terra Nova.

Where it does matter is on the valuation of TTT shares (or their book value). Those 990k shares of KHD are worth around $8.9m at KHD’s current share price of about $9.

KHD shares were accounted for as level 3 assets on Terra Nova’s balance sheet in the third quarter, with a value of just $32,678,000 (“Investment in a former subsidiary”) for 7,244,901 shares (assuming 25,115,927 distributed shares). This amounts to a valuation of just $4.51 per KHD share, approximately book value or half the current share price.

Quote from Terra Nova’s 3rd quarter SEC-filing:

Management is of the opinion that the KID common shares were not quoted in an active market at March 31, June 30 and September 30, 2010. At March 31, June 30 and September 30, 2010, the KID common shares were measured using Level 3 fair value hierarchy. The valuation was based on the earnings forecast of the operations of industrial plant technology, equipment and service business, as well as the expected earning multiple and discount rate. The KID common shares represented the only item in the Level 3 fair value hierarchy.

If my calculations above are correct, then Terra Nova should still own slightly less than 3% of KHD Humboldt Wedag International AG. These shares would have a market value of $8.9m, but are carried on the balance sheet at only around $4.5m.

A valuation of these shares at market price could mean a potential book value or earnings surprise in the current year of $4.4m, or around $0.07 per share.

If Terra Nova participates in the rights issue of KHD that starts next week (this would make sense since the subscription rights, which have value, cannot be sold), it would cost TTT around $3m to participate (495k shares X EUR 4.53 X 1.33 EUR/USD), but would increase total holdings of KHD shares to around 1.48m shares. The theoretical ex-rights price of KHD can be calculated (in EUR) as
formula for ex-rights price
which would be around EUR 6.18 or $8.21 at the current KHD market price.

At this price, Terra Nova’s holding would be worth $12.2m, with a balance sheet cost of $4.5m+$3m=$7.5m, thus giving a potential revaluation benefit of $4.7m, or 7.5 cents per share. Of course, should KHD trade higher, the benefit could be much more (or less, if KHD shares fall). A sale at market price might also have tax consequences for the company.

While these four to five million dollars represent only about one percent of Terra Nova’s market value, it shows there are still potential surprises on TTT’s balance sheet. I think it is probably safe to say that many more of these types of surprises can be expected during the course of 2011, as Mass Financial’s holdings are hopefully going to be revealed in more detail.

Disclosure: I am long TTT. Long shares of KHD Humboldt Wedag AG, will participate in the upcoming rights issue.