THE MOST BORING SUCCESS IN CANADIAN EQUITIES?

WESTAIM CORP — WED-TSXv / WEDXF-OTC

When they get big, REALLY big, asset management firms can do big deals, and they make the news–like BlackRock, KKR, etc–in Canada you can think of Brookfield or ONEX.

The Big Guys here have some mystery to them because they’re…opaque. They buy and sell companies and use sophisticated hedging techniques. They’re almost sexy.

Westaim is a baby-asset manager, and is definitely not that. In fact, they might be the most boring success story in Canada. Management has put up great ROI for the business, but the stock has been a value trap for 10 years.

However, that could change now as their AUM–Assets Under Management–crests $3.5 billion (yes that still qualifies them as a toddler in this Big Person game), and fee income meets costs.

This stock came to my attention because it’s a small cap stock hitting 10-year highs, on the back of a spinout IPO this year in a NASD-listed insurer called Skyward (SKWD-NASD)–adding US$87 M in non-dilutive capital to their coffers.

The question now is–what does competent, conservative team do with a huge new influx of money. They’re definitely not going to Vegas; that’s not in their blood. We had a great chat with President/CEO Cam MacDonald and COO Robert Kittel, peeling back the layers and getting a sense of what’s next.

After all that I confess I’m still not long, but if I had a bit more of Warren Buffett in me I probably would be.

The I find sum-of-the-parts stock ideas to be a tough sell. They always trade at a discount, and have long term horizons. For retail investors, that’s not always easy.

What is a sum-of-the-part idea? It is a stock where the value isn’t immediately obvious because the company is made up of a bunch of pieces. If you dig into each piece and add up the whole–you will find it to be undervalued.

Westaim (WED-TSXv) is one of these companies. I lay out the full story here, and it’s complicated (sorry! but that’s what we do here). But it has just had a big catalyst that management could use to change the story–at least a bit–around the stock and potentially see a re-rate.

But let me back up. Why do I find this kind of situation a tough sell?

Strike one is that sum-of-the-parts stocks are almost always asset plays – which means that the quarterly earnings releases are non-events. 

Second, they tend to be value-traps – yeah, the value is there, but will I be old and grey by the time anyone cares? The 10 year chart here bears that out.

Strike three is that “the parts” are usually not that interesting.

Westaim Corp had all three strikes against it. It was an asset play that no one cared about, made up of an insurance company and an asset manager.

For the longest time, the stock performed just like the value-trap it appeared to be.

Then–just a month ago–BOOM

Here’s the longer 10 year chart:

WHAT HAPPENED?
TECH SPIN-OUT BRINGS IN US$90 MILLION

When a long-time laggard like Westaim goes on a parabolic run, something must have happened.  In this case, what happened was the IPO of the insurance company, Skyward Specialty Insurance (SKWD – NASDAQ).

Westaim owns 14.6 million shares, or 37% of outstanding shares, of Skyward.

Skyward went public on the Nasdaq on January 18^th at $15 per share. Since that time the stock has risen to $24 per share.

That has led to a cool US$130 million of incremental value to Westaim. Their position in Skyward is worth US$350 million today.

A few months ago, none of this was in the stock. As recently as Q3 2022, Westaim valued Skyward at only C$187 million.

While Westaim was valuing the Skyward at fair value their pre-IPO estimate of that was book value. It’s a nice, conservative valuation.  But most good insurance companies are valued at a multiple to book value.

A recent note from Morgan Stanley showed that with only a few exceptions, P&C insurance valuations lump together at around 2x P/B.

Because Westaim accounts for Skyward as an investment, much of that increase in NAV was reflected in their Q1 results. On March 31st, Westaim valued their position at US$319 million.

WHAT WILL THEY DO WITH ALL THAT CASH???

Westaim isn’t waiting around to see how Skyward plays out. They took a sizable amount of stock off the table in a secondary offering.

Westaim sold 3.988 million shares of Skyward for US$23 per share. That nets Westaim US$87.4 million, or about $120 million Canadian.

With 141 million shares outstanding, Westaim’s market cap is a little less than C$500 million. In other words: this is a significant injection of cash.

What are they going to do with that cash?

The lone brokerage firm that covers the company, thinks a substantial issuer bid (SIB) is in the cards.

This Canadian boutique said in a note this month that Westaim could announce a $4/share SIB that would be accretive to the stock and still a 13.5% discount to book value. A value investor’s dream!!!

That’s right, at $4 per share Westaim still would trade at a discount to book. In fact, at $3.60 per share the stock price barely covers the C$500 million investment in Skyward and the cash they just took out.

That means you are effectively get the other businesses for free.

IT COULD BE EVEN BETTER….

The rest of Westaim should be worth a lot more than that.

Westaim has a 51% ownership in an asset management firm called Arena Investors. They also have a significant amount of their own capital invested in Arena originated products via their Arena FINCOs subsidiary.

Let’s start with Arena Investors.

Like Skyward, the investment in Arena Investors is marked at fair value – but that value is largely derived from a $24 million loan that Westaim has made to Arena. Westaim’s upside here isn’t the loan – its their 51% ownership in the asset management firm, which could turn out to be worth a lot more over time.

What does Arena Investors do? To put it simply, they invest. And history shows they’re pretty darn good at it.

What do they invest in? Just about everything.

I’m kidding. Sort of. There is no theme here that I could see.

Arena deploys cash pretty much anywhere it sees a good risk /return profile.  Private investment, structured finance, real estate, consumer assets or corporate equity. Its wide open.

Arena is a private equity firm. They raise capital from investors and invest it in closed or open-ended funds as well as separate accounts.  

At YE 2022 Arena managed $3.5 billion of assets under management (AUM). By Q1 2023, this had come down a little to $3.3b.

AUM has been growing consistently since 2015.

Arena has a number of funds in the works to increase AUM further.

Together these funds should add almost another $2 billion on AUM.

Like all investment management firms, Arena collects a modest management fee. But the big return comes from incentive fees.

Incentive fees kick in if Arena is doing a good job. If Arena exceeds their expected return for a fund, they receive an outsized portion of the excess.

Incentive fees can be lucrative, but they are also variable. Like a lot of investor management firms Arena had a tough 2022 with very little in the way of incentive fees.

But the 2021 results give you a taste of what Arena can accomplish in a more positive environment. In 2021, Arena generated $21 million in net incentive fees. 

While incentive fees are easy-come, easy-go, Westaim’s base fee income (mainly management and servicing fees) have been increasing each year as Arena grows AUM.  These fees appear to have reached past the break-even level to where additional fees should largely drop to the bottom line.

Like most things at Westaim, their investment in Arena is a little complicated.

Arena and Westaim have structured their relationship such that Westaim’s effective ownership percentage declines as AUM and margin increases.

Westaim ownership of profits drops to 25% as AUM increases at $5 billion. Of course, the bigger AUM means bigger fees, so Westaim should still see the benefit of growth.  Arena’s management team just sees more, but that is what incentives are all about.

Some investors–like me–aren’t big fans of this. But it does keep mgmt incentivized to be good long term investors.

ARENA INVESTORS – IMPRESSIVE TRACK RECORD

In mid-May Westaim did an investor day as part of their annual meeting. 

The majority of that presentation was given by Dan Zwirn, the CEO and chief investment officer of Arena.

Zwirn’s presentation was anything but cheerleading.  While his message was that Arena can prosper in both good times and bad, he didn’t mince words – Arena expects that times will get worse before they get better.

Zwirn referred to “the bubble” too many times to count. In fact, 3 whole slides were dedicated to describing what Arena did and did not do during the bubble!

Arena expects to see more problems surfacing in commercial real estate (and not just office). More corporations going bankrupt. More delinquencies in consumer finance. It is not a pretty picture.

To counter Arena’s concern on the overall environment they have bought insurance. Every month they take 8 bps of portfolio insurance, saying if the S&P is down 20% in a month, they are going to insure they are rewarded “handsomely”.

The upside is that Arena has the skill-set to take advantage of this kind of environment, to take advantage of “all these terribly priced and misstructured assets”.

They have the track record to back that up. On 174 prior investments that they have already exited, their IRR is 17.1% gross return.

How does Arena do it?  Zwirn summed up their strategy like this: Arena “likes defaults.”

That may sound strange, but what it means is that Arena is all about working out problem loans before they get out of hand. Covenants are strict and strictly enforced.

Management does not see themselves as “vulture investing”. Arena isn’t making loans that they want to go bad. But they are also not afraid of loans going bad. While some firms prefer to extend and pretend rather than face defaults Arena wants to confront a problem head-on, with the covenants to enforce change before it goes south.

Their strategy is short duration (1-3 years), high interest rates, variable interest rates and modest loan-to-values.

The focus is “leverage and severity”. That means keeping leverage low, and if something goes wrong make sure they have tight enough restrictions that they can catch the problem fast, limiting severity.

This is an acquire-build-harvest business–which means that it can be slow. And it isn’t always a great vehicle as a public stock. But if done right, the stock can have big moves, like the one we just saw.

ARENA FINCOS

The reason I am spending so much time on Westaim’s small $28 million investment in Arena Investors is that the far larger investment in Arena FINCOs depends on it.

Arena Investors are the investors. Arena FINCOs are the investments themselves.

Arena FINCOs are two subsidiaries of Westaim that hold assets invested in corporate private credit, real estate private credit, commercial/industrial Assets, and consumer assets.

These are all loans and securities originated by Arena Investors.

Arena FINCOs receives interest income, dividend income and/or investment-related fees.

What are these loans? Westaim gives a lot of detail in their MD&A, going so far as to list out of loan metrics one-by-one. Taken together, these are mostly high interest (>10% interest rate on average), first-lien loans against a wide variety of businesses.

Arena FINCOs is valued at book value.  Which in this case is appropriate, as book value is the best estimate of the fair value of the loans and securities that are held by Arena. Arena was valued at US$153 million at the end of Q1.

DOES INSIDER BUYING
POINT TO MORE FIREWORKS?

The insider buying has been a harbinger of stock performance in the past.

I started looking at Westaim after some big insider buys beginning in 2020. These big buys were by Jim Hays. They were followed up by other insiders buying whenever the stock got into the low $2 range.

Hays was the operator of the Minneapolis based insurance company Hays Companies before it was bought by Brown & Brown for $700 million.

Hays knows insurance, and I suspected he may understand the value that could be unlocked with Skyward.

But my assumption was that after the valuing creating event (ie. the Skyward IPO), you’d see insider buying taper off. Maybe even reverse.

That hasn’t been the case.

The insider buying has continued, even as recently as a couple of weeks ago.

What does this continued insider buying mean?

For one, it means that insiders still see the stock as undervalued – even after the IPO–which is not all that surprising given that Westaim trades below book value.

It could also mean that there is more to come–with the most likely event being an SIB.

When I talked with Westaim management, I got the feeling they wanted to keep their options open. For now, the best use of cash was to buy their own shares. 

To me, that means more of the same–which has been very good! But this is not a glitzy team; you don’t see a lot of press releases meant to keep retail investor interest up.

Kittel and MacFarlane say they overbuilt their structure for scale–and now the business size has caught up to the team and its capabilities.

That means every new dollar will have an outsized impact on positive cash flow than ever before. With their track record, that is likely enough to keep the stock moving north from its tight 10 year trading range.