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Urbana Corporation: buying stock exchanges at a discount

|Includes:CBOE Holdings (CBOE), NYX, UBAAF, URNAF

Today I'll be looking at Urbana Corporation, a company that received attention earlier this year at various blogs (reading material @ Free NPV, Kerrisdale Capital, Barel Karsan). Since that time plenty has happened that warrants a fresh look. Urbana is an easy to understand business that is actually not really a business: it acts as a closed end fund that invests in stock exchanges world wide. They invest in exchanges when they are privately owned and try to realize value when they are transformed to a public company. The company reports it's NAV weekly, and was at 1 December trading at a discount of 46% to NAV. A nice spreadsheet that updates the NAV in real time can be found here.

The majority of the assets sit at the moment publicly traded securities, making it easy to confirm that the reported NAV is actually correct. The biggest holdings of the company are CBOE and NYX, good for 31.75% and 35.64% of the portfolio value. It also holds some smaller public investments, while 26.95% of the value is in private exchanges. By far the biggest holding in that category is the Bombay Stock Exchange that represents 13.42% of the portfolio value. Most of the holdings in the private exchange category have been written down significantly the past years (in line with the public holdings) and seem to be fairly valued. A discount due to the liquidity of the holdings, and the uncertainty of the market value is probably warranted, but since these holdings are just a small part of the portfolio it's not going to materially alter the investment case. Some key statistics about the company/the portfolio:

Last Price: 0.97
Shares outstanding: 75.1M
Market Cap: 69.0M
Value of public investments: 104M
Value of private investments: 38M
Debt: 14.3M
NAV: 135.2M
NAV/share: 1.80

Results have been pretty poor since the start of the financial crisis, not only as a result of the crisis it self (high trading volumes are good for profitability), but trading volumes are also moving to alternative stock exchanges in the US. NAV has dropped with nearly 50% from a peak of 260M at the end of 2007 to the current 135M. The company has been buying back reasonable amounts of stock at a discount since the beginning of 2010, reducing the shares outstanding from 87.5M to 75.1M (14%). The following graph shows the historical NAV, the amount of shares outstanding, and the NAV/share.

While results have been bad since the financial crisis, historical results have been pretty good. The company reports that since October 1, 2002, when Caldwell Investment Management Ltd. started managing the company's investment portfolio, to December 30, 2010 it achieved a CAGR of 15.69%. Because of this it used to trade at a (ridiculous) premium before the financial crisis, but has been trading at a discount ever since that recently hit record highs. All numbers are based on the share price of the common shares, the Class A shares are often trading at a higher discount.

So far it's looking good: we can almost buy a dollar for 50 cents here, and if we don't particularly like the companies Urbana invested in we can fairly easily hedge our self against the NAV dropping because the majority consists of two big liquid companies.


Unfortunately not everything is perfect about Urbana. There is a investment management fee of 1.5% for the equities in the portfolio (note: this generates an incentive for management to keep the prices of the private investments artificially high on the books). There are also trading expenses and other corporate overhead creating a total expense ratio of roughly 3 percent: making URB.TO an expensive way to hold CBOE and NYX. The latest annual report provides the following table:

To get the TER we need to add the management expense ratio and the trading expense ratio together. A positive note: the portfolio turnover ratio is very low, resulting in low trading expenses. The most logical way to calculate what kind of discount the shares should trade at based on these expenses, is trying to calculate what percentage of the NAV is required to cover the fees. If the annualized return on equity in the long run is 3%, and it costs 3% to run the portfolio the investment in the company is basically worthless, because it doesn't generate a single cent of intrinsic value growth or cash flow for share holders. In that case there would only be value if the company gets liquidated at some point. With an expected annualized return on equity of 6% a discount of 50% seems suitable, because basically just half of the value generated by the business goes towards shareholders and with an expected annualized return on equity of 9% a discount of 33% is warranted. Given an average annualized return on the S&P500 of roughly 9% from 1900 till today the discount of 46% seems on the high side, but is actually not that crazy if we don't expect that the company is going to liquidate.

In the past the company significantly outperformed the S&P/TSX Composite Index that they use as benchmark, so maybe assuming market returns is a bit harsh. They have returned a CAGR after fees of 15.69% while the benchmark returned 9.98%. But with such a concentrated portfolio benchmarking doesn't make a lot of sense.

A sanity check is see at what kind of discounts closed end funds trade. Morningstar provides a list of several CEF that can be sorted on premium/discount. The biggest discount in that list is 35%, confirming that a 46% discount is big.

Shareholders versus Management: it's complicated

A shareholder friendly management could easily generate great returns for share holders by simply buying back shares at a discount, and the company has been doing that for the past two years. If you look at the first graph in this post you see that since 2010 NAV/share has been diverging from NAV thanks to the buy backs. They have been buying back shares at a rate of 10%/year, and at today's prices and with today's 45% discount, that would add 7,548,950 * (1.77 - 0.95) = 6,190,139 dollar in value per year. Divided over the 67,940,550 remaining shares it would create an increase in NAV/share of 0.091 dollar, or 5.25%/year (while dropping total NAV with 5.36%). This is more than enough to compensate for the expenses! And if the discount drops: that is great, since that would imply that the (relative) market value of our shares is going up.

The problem - for management - with the share buybacks is that buying back shares is equal to slowly liquidating the company, and the destruction of a valuable management fee. Thomas S. Caldwell made 2.4M in fees in 2010, and if we assume a zero growth rate and a 10% discount rate, the net present value of that cash flow is 24M. The management of Urbana owns 4,456,161 shares (The CEO owns the majority with 4,231,161 shares), and his son owns 1,031,163 shares for a total of 5,487,322 shares with a value of 5.1M dollars. So even though management owns 5.5M shares, there is no incentive to liquidate the business since that would result in a gain of ~5M on the shares (and freeing up 5M of capital), while giving up a cash flow that worth 20M+.

The fact that Thomas S. Cardwell bought 1M shares in March this year is also not directly a positive indicator. The company has a dual class share structure with 10M common shares that have all the voting rights, and 65M Class A shares that have equal economic rights, but no vote. With the latest purchase TSC controls 47.59% of the votes, so it looks more as a buy designed to keep control over the company, and the cash flow from the management fee. But in case of a take-over bid the Class A shares would temporary get voting rights, so unless he owns more than 50% of all outstanding shares his position remains vulnerable. I'm no expert on Canadian security laws, so take this with a grain of salt.

With that fact it is actually interesting that URB-A.TO is often trading at a discount relative to URB.TO. The voting rights aren't that valuable with TSC effectively in control, and they are a lot more liquid because of the higher number of shares outstanding. In the past the voting premium has been as big as 30%, but it's also capable of moving into the negative territory. That doesn't have to be irrational, the higher liquidity of the URB-A.TO shares should be worth something too, but I don't think there is a rational explanation for the rapid changes in the discount. But it might offer some opportunities in the future to profitably switch between the two share classes.

In one important aspect share holder interest are aligned with the CEO, and that is with regards to not do anything stupid with the assets under management. Since he is paid a fee based on the size of the assets, he does have a strong incentive to not destroy value, since it would imply destroying their cash flow. And management having shares worth 5.1M doesn't hurt either.

So what will happen? In the beginning of this month shareholders sent a letter requesting more aggressive buybacks, and TSC replied:

We do plan to build this company and our goal is significantly above its current size. I would not like to run our size down too much.

So we don't have to count on a fast arbitrage from the company between it's share price and NAV. This event could very well explain why the discount is currently at record highs, although it has been getting higher in the previous months as well. But on the other hand, there is also no reason to believe that the current share buy backs will be stopped. In the latest annual report TSC wrote the following (released May 31, 2011):

In regard to Urbana’s share price, the environment of the past three years was further exacerbated by a few major Fund holders of the “A” shares becoming sellers in order to match their own fund redemptions. The nature of this selling tended to be in larger blocks directed straight into the market. The resulting discount of Urbana’s share price to the underlying asset value represented a significant opportunity for Urbana to profitably buy back and cancel “A” shares. Urbana purchased and cancelled in excess of 10% of its outstanding “A” shares as of the date of this report.

Urbana’s management anticipates continuing this program, to the extent allowed under Toronto Stock Exchange regulations, as long as a significant discount continues to exist.

Since then the company also announced a new share buy back program on August 25, 2011 to buy back 10% of shares. The discount between price and NAV has only grown, so I think we should expect that the share buybacks are going to continue in the foreseeable future. A good thing about that is, that it also slowly aligns management interests more with share holder interests. It increases the value of the shares of management, and it decreases the value of the management fee. But there is a limit to the amount of shares we should expect management to buy back since they don't want to liquidate a too big part of the company.

Another important consideration is the fact that Urbana is actually not a big part of the CEO's income or wealth. Caldwell Securities, founded by Thomas S. Caldwell, list Urbana Corporation as just one of eleven funds that they manage. They also have other activities such as wealth management for high net worth individuals/institutions. He owns 44.90% of Caldwell Securities while his son owns 22.58% of the company. Screwing over share holders in URB would presumable not be good for the more important business, especially not if he ever wants to launch a new CEF in the future.

And a final note about the CEO: TSC has been governor of the Toronto Stock Exchange in the past, explaining the focus of Urbana. Caldwell Investments (founded in 1980) actually runs three other funds that are exchange focused.


So how exactly should we value URB? If we assume no alpha generating abilities from management a big discount because of the ~3% TER is in order. With the current discount the assets are priced as if they are able to return a CAGR of roughly 6/7% in the long run, roughly 3% below the average CAGR of the S&P500 giving us a reasonable margin of error at today's prices. But this alone would not be enough for me.

The fact that the company is buying back approximately 10% of shares/year on average, and is expected to continue this program while the discount between NAV and the share price is big, creates significant share holder value each year. The stock buy backs would add 5% to the NAV/Share, while the expenses reduce it with 3%. At the same time we are able to buy stock for almost 50 cent on the dollar. It's not as great as buying something for 50 cent, and reselling it for a dollar in a short period of time, but it's still pretty good. If the share buy backs would be stopped the current valuation is reasonable conservative, and if management is actually capable and able to maintain the historical CAGR the current share price is truly a steal.

Disclosure: I am long UBAA.PK.

Additional disclosure: Long URB-A.TO, short a little bit NYX and CBOE