The Rabbit in the Hat May Be the Real Deal

Alex is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Late last year after MFC Industrial (NYSE: MIL) reported its third quarter earnings, I published an article titled Did MFC Industrial Just Pull a Rabbit Out of Its Hat? to shed some light on the 46% increase in stated book value. This was a huge quarter-over-quarter increase and included some accounting entries not associated with an acquisition.

What was the rabbit?

The rabbit was the recording of negative goodwill in conjunction with its acquisition of oil and gas company Compton Petroleum. This resulted in a gain of $230.1 million and helped push total assets over $1.3 billion, which were up from approximately $871 million at the end of the prior quarter. There was little doubt that MFC purchased the Compton assets at a significant discount, but many investors doubted the value placed on the assets by MFC. While this led to a stated book value of $12.79 per share up from $8.98 at the end of the prior quarter, the stock was up only $0.20 on the day of the announcement to $8.19 per share, which was a clear signal the market was not a believer.

Is the stated value real? That is the question many investors are asking themselves as they evaluate an investment in MFC. However, the company’s third quarter conference call gave me a little more confidence that the numbers are at least reasonable. Unfortunately for the company and the stock, the conference call revealed the good, the bad and the ugly. The market focused primarily on the ugly.

The good

During the question and answer portion of the call, Joe Pratt of Wells Fargo Advisors inquired about the Compton assets and more specifically about the non-core assets classified as held-for-sale on the balance sheet that are being actively marketed and seeing bids. He asked that Chairman and CEO, Michael Smith elaborate on how the process was going which he did, but the comments did not reveal much new information. It was a follow up question by Mr. Pratt that revealed what might be the best insight into the valuation of the Compton assets. Mr. Pratt asked Mr. Smith if he could anticipate a write-down in the event of a transaction. Mr. Smith responded very confidently, “Yes, assuming there was a transaction, there will be no write-down, and I'm comfortable with the carrying value.” This was the second statement by Mr. Smith that he was very comfortable that no write-down will occur on the Compton assets held for sale.

This was music to my ears. In my earlier article noted above, the assets held for sale were to serve as my benchmark as to whether the valuation was fair. If the Compton assets held for sale were sold for an amount equal to or greater than the carrying value, it would signal that the remaining assets to be used in the ongoing supply chain business were fairly valued. In addition, Mr. Smith later confirmed if the assets sold for the net book value that the MFC would retain the entire amount net of tax, which would be approximately $100 million.

The bad

On Mar. 11, Cliffs Natural Resource (NYSE: CLF) announced plans to idle its Wabush Pointe Noire pellet plant in Sept-Iles, Quebec. For those investors that follow MFC and other companies that might impact MFC this was not a surprise. It is important to MFC due to the royalty interest the company holds in the Wabush mine. However, the news was not all bad as Cliffs did disclose production guidance of 3 million tons, which is in line with previous production. So while this will continue to be a concern, the royalty appears reasonably safe for 2013.

The ugly

During 2012, MFC recorded an impairment charge of $42.6 million and a write-off $19.4 million in inventories related to its ferrous metals mining interests in India. According to the company, the State of Goa halted all mining activity in September 2012 and a month later the Supreme Court of India stayed all mining operations. This decision also included a halt on the transport of minerals already mined. The company believes it may be many years before this situation works itself out in the courts. As a result the company elected to exit its mining operations in India and record a total impairment charge of $48.2 million net of tax benefits during 2012. This news was not totally unexpected, but the negative reaction of the stock on the day of the conference call indicated some investors may have been caught off guard.

The subsidiary was sold during the first quarter of 2013 and MFC no longer has any cash flow obligations. However, MFC did retain rights to a portion of future cash flows if the mine ever were to come back online.

The bottom line

The results and news coming from the earnings release and the conference call were certainly not the most positive in nature which resulted in a further sell off of the stock. However, the recent decline may be an opportunity for investors to buy the stock at an even greater discount to book value. The sale of the non-core Compton properties is yet to transpire. However, the company did recently market the properties and management was very confident with the valuations placed on the assets held for sale. This should give some confidence to investors that the core Compton assets being held are most likely fairly valued as well. At current valuations, the stock trades at a significant discount to book value even with the write-down of the India operations. There is certainly still risk in the Wabush royalty as well, but as the company makes further acquisitions to support its supply chain business, the income and book value of this royalty continues to become less significant. In addition, the recent strength in natural gas prices only adds to the value of the Compton assets.

Alex Gray owns shares of MFC Industrial Ltd. The Motley Fool recommends MFC Industrial and Wells Fargo. The Motley Fool owns shares of Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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