Consolidated Mercantile: Cash Rich Canadian Microcap

Consolidated Mercantile (CSLMF) is a cash rich Canadian microcap holding company. Recent monetizations of deficitary holdings should put cash/short term investments at $1 per 45c market price and put an end to losses. The company will have no debt. This will become apparent when the company releases their annual report (likely at the end of March).

Background

CSLMF is a Canadian holding company. Recently they have owned PolyAir, a Canadian manufacturer of packaging products, and Distinctive, a Canadian furniture manufacturer. Both investments have initially worked out well for them, but over the last few years due to China imports and the devaluation of the US dollar (US is the main target market for Distinctive) they have bled cash like crazy, losing about $3M in 2006 and 2007 (although part of that loss was a write-down on the PolyAir investment which was later recovered as we will see).

Recent events

CSLMF showed up on one of my value screens due to its very high cash and short term investment holdings ($10.3M) relative to market capitalization ($6.3M) in mid 2007. I researched their latest SEDAR financial filings and found that their 22% holding in PolyAir had been written down to zero even though the market price for their holding was at that point $5.4M, bringing up cash and securities to $15.7M. Book Value at the same time was $12.4.

So you had a company with $15.7M in cash and securities and $12.4M in book trading at $6.3M.

The market rarely gives you $2.50 in value for the dollar - so there was a catch. Both PolyAir and Distinctive were bleeding cash and it was not clear whether and when management would be rational and cut their losses. When CSLMF announced on July 13, 2007 that they intended to sell Distinctive, I took a small position (given that intent does not equate success - or a good price). When Distinctive announced a little later they'd be restructuring their unsecured obligations, I started to get worried.

Around the turn of the year came the good news: The 22% holding in PolyAir was sold for $6.2M - at a sizable premium to market. Also Distinctive was sold. With Distinctive's horrid performance over the last few years, I would have expected CSLMF to have to forgive loans or similar to be able to exit.

But it turns out, CLSMF will still get their loans to Distinctive of about $828k repaid plus will receive a promissory note $1M payable over 10 years in return for the equity. Given the state of Distinctive, it's not clear whether that note will ever really be paid - but it is secured at least partially by the life insurance of the acquirer. At a minimum, given 10 yearly payments of $100k you'd have to discount later payments. I'm hesitant to assign more that $300k in actual value to this part of the deal. Not great - but at least there's and end to this disastrous investment.

Valuation

So what will things look like when CSLMF reports their full year results (usually at the end of March)? Let's work from their most recent quarterly filing. Given that Distinctive is very close to bankruptcy any cash or security holdings are likely at the holding level and will be unaffected by the deconsolidation of Distinctive. Accounts receivable, Inventories, Prepaid expenses, Property and Equipment, Commercial credit facilities, Accounts payable, Long term debt and the postponed liability under the debt restructuring of Distinctive will all largely disappear due to the consolidation. Similarly, the non-controlling interest will go. I'm not clear what happens to the income tax liability (which is small). On the Equity side, we have the accumulated other comprehensive loss which, again, should largely disappear due to the divestiture of PolyAir and Distinctive.

CSLMF has non capital tax carry-forwards of about $2.2M. Their cost basis in the PolyAir share is likely lower than the $3.98 they were able to get in the sale. Capital gains are taxed at 1/2 of corporate taxes - to be conservative, calculate with a cost basis of 0 and come out with taxes under $1M. So their after-tax proceeds on the PolyAir sale will be "> $5M.

Bringing it all together:

So we have (US$ / C$ = 1 for simplification, which is correct as I write this):

Assets:

• C $4.163M in Cash and equivalents
• C $6.148M in Short-term investments
• US $5.000M in after tax PolyAir proceeds.
• C $0.828M in loan repayments for Distinctive
• C $0.300M in value for the Distinctive note
• C $0.617M in Investments

Liabilities:

• C $1.006M in Income taxes payable
• US $16.050M in Equity

Or about $3.16 in liquid assets per share. The stock currently trades at $1.45.

Ownership and Management Team

CSLMF is majority owed by its CEO Fred Litwin. There's a bit of a labyrinth of small related companies with his involvement here (Forum, GenTerra, etc). I spoke to their CFO Stan Abramowitz, which made a good impression on me overall and clearly answered my questions. The companies share administrative services, so you don't initially actually get someone from CSLMF on the phone. As long as that's all to reduce cost - fine with me.

Risks

CSLMF has been a very thinly traded stock over much of last year - with often less than 1k pieces traded per day. However, during January, volumes have escalated with as many as 100k changing hands per day. Much of this seems to be the effect of Prides Capital Partners disposing of their 8% stake (see Edgar filings). These guys have been broad sellers in many issues and their fund isn't doing well, so we may be seeing the effects of fund redemptions here. This has not only increased CSLMF trading volumes, but also decreased prices making this opportunity so attractive. However, it may take time to sell later at higher prices.

Although I find it quite respectable how CSLMF got our of their two cash burning investments, if you go back over the years, capital allocation certainly hasn't recently been a particular strength of this management team. Short term investments tend to generate losses even if the markets are up overall. One could argue that the impact of Chinese competitionon packaging should not have come as a huge surprise, nor did the real estate downturn in the US - did they take action too late?

The company has an normal course issuer bid out for 5% of it's stock. And you'd believe they'd have all incentive to purchase back at this moment. Tax free return on capital cannot be had much cheaper than by purchasing $3.16 in liquid assets for $1.30 (which is where the stock has traded for some time). I have all indications that the company could have purchased 5% of its stock at $1.30 from Prides Capital - and I have alerted their management to this opportunity. However, I have neither heard back from Management or seen any indications in the market that purchases by CSLMF had been occurring. Which makes one wonder how high of a priority share holder value maximation is for these guys.

CEO Litwin owns the majority of the company and, given its size, there is the obvious potential conflict of interest between minority shareholders and the managing dominant shareholder. CSLMF has no staff but pays sizable amounts to related parties for services provided to the company. C$240k were paid for administrative services in 2006 (including Litwin's salary). It remains to be seen how these amounts develop now that there are no active operational investments. In absolute terms this doesn't necessarily seem excessive - but given the small asset base of the company I'll closely watch whether shareholders get a reasonable return on these outlays.

The company assures investors it will now focus on finding new attractive investment opportunities for the fresh funds - which will continue justifying their salaries at current levels.

Summary

I have very rarely seen stable companies at such discounts to liquid fair value. Given the narrow market, this is only a stock for small investors (and they need to use limit orders!). But once the numbers for 2007 get reported, this could easily become a winner. Even given the risks, I personally tool a sizable position around $1.30.

Disclosure: The author is long CSLMF.

Comments

[twgilliam@e...:]

Interesting analysis. Send me your e mail address and/or tel. # and let's talk further.

2008 Feb 21 10:52 AM

[valuemanager03:]

Excellent analysis and post. I have followed this company for a while and felt the *exact* same... but you have done a quite thorough job putting it in print.

I too thought the company would have had a great deal buying Prides Capital's shares (incredibly book value accretive, including to Litwin's stake). But they didn't. I guess they want to save the cash to maximize value of the next deal? I wonder, too, if age is catching up with the managers (not to say they are diminished by age, but do they still want make 5 to 10 year investments in their 70's???).

As a shareholder, I'd be happy with a liquidation of that $3 plus cash. More likely, they'll make some deal. Even if they destroy shareholder value in another deal... it would have to be 50% loss to break-even. Anything with a decent ROI would mean shareholders turn out marvelously. It's like a SPAC, but so much better since we are paying 1/2 of the cash value, and there are no warrants to dilute the upside.

2008 Feb 21 03:13 PM