Sunday, March 21, 2010

A Special Situation in Canada, hey?

I’m writing to introduce MDS Inc., which is one of my portfolio holdings (ticker is MDZ). MDS is undergoing a significant transformation, and as a result I think there is a special-situation-type investment that could produce very good returns.

WARNING: This is one of my first “special situation” investments; my past performance has been driven by plain old value investing (see the “My Returns so Far…” link). So, please recognize there’s a chance my thesis could be flat-out wrong. Additionally, I’m a little nervous b/c there are no structural characteristics that would create a mispricing (i.e. spinoffs and companies coming out of bankruptcy may have forced/non-discriminating sellers, which can create an opportunity to buy the stock cheap). BTW if you haven’t read Joel Greenblatt’s excellent book, “You Can be a Stock Market Genius,” I highly recommend picking up a copy as it’s a great introduction to special situation investing.

Anyway, back to MDS. First go to to learn the basics about the company’s operations and transformation. As you can see, it’s all about their Nordion division going forward. Nordion gets their isotopes (which are used for medical applications) from a very old nuclear reactor run by the Canadian government, and the reactor ain’t doing so hot (no pun intended). However, if the reactor has a good year Nordion can earn about 75 MM in EBITDA, but if the reactor has a bad year then there’s a supply disruption and results suffer. So let’s be conservative and say this business is worth 4x our assumed EBITDA, or 300 MM. Currently, MDS has a market cap of 1B, but due to a recent divestiture they’ve also got about 650 MM of net cash on their balance sheet.

So here’s where it gets interesting; 400 to 450 MM of that cash (let’s just say 425 MM) will be used to repurchase shares via a Reverse Dutch Auction. Based on the auction price range, 40% to 46% of all outstanding shares will be retired (let’s just say 43%).

After the auction, MDS will have 650 less 425, or 225 MM of cash on their balance sheet. They’ll also have a market cap of 570 MM (current market cap less 43%). This gives them an Enterprise Value of 345 MM. NOTE: This makes sense – remember we gave MDS an EV of 300 MM, so we’re in the same ballpark. Thus, the logical conclusion is the market is valuing MDS fairly and there’s no opportunity here.

But Wait! MDS is suing the Canadian government for 1.6 billion (yes, with a “b”)! It turns out MDS had invested 350 MM with the government to build a new reactor. However, after running into significant problems and budget overages, the government suspended construction. As a result, MDS is suing to get their initial investment back along with the foregone profits that surely would’ve ensued had the government actually built the plant.

So, here are the possible outcomes:

1) MDS loses the lawsuit and, because they can’t get the new reactor online, Canada discontinues their nuclear program. In this case MDS is really not worth much more than the cash on their balance sheet, Ouch!

2) MDS loses the lawsuit and continues getting isotopes from the problem riddled nuclear plant. MY guess is not much will happen to the stock price here, as it appears the market is already valuing the stock under this assumption.

3) MDS wins the lawsuit. With 225 MM in cash and a market cap of 570 MM, a settlement of 350 MM will basically bring MDS’s cash balance up to today’s market cap. In other words, you get the business for free!

4) The Canadian government says to heck with it and finishes building the new plant. With a predictable, steady stream of isotopes MDS could probably earn about 100 MM in EBITDA. Also, the market would probably pay a premium, maybe as high as 8 to 12x.

Some last items worth mentioning. It looks like MDS management as well as the largest shareholder will be holding on to their shares, which is definitely a good sign (see FAQ's on the MDS website). I have no insight into the timing of the lawsuit/settlement, but my guess is management wants to do the auction b/c it will be resolved sooner rather than later. Also, my guess is management would not change the operations and capital structure of MDS so radically if they did not have confidence in Nordion going forward, which makes me think outcome #3 or #4 is more likely than #1 or #2. Lastly, MDS is just over 10% of my portfolio as of today.