Sprotts hot, but that price could burn

Date: Tuesday, May 6, 2008
Author: Derek DeCloet, The Globe and Mail.com

There will be fistfights and bloody noses this week on Bay Street over the Sprott IPO. To buy shares? Well, yes. But also among short sellers who will be scrambling to borrow them.

Nobody knows the value of a hedge fund like a hedge fund manager. And there is no hedge fund manager in Canada like Eric Sprott. The legend hardly needs polishing, but in case you just got back from eight years in a Siberian prison, perhaps one number will suffice. A $10,000 investment made a decade ago in his largest mutual fund is $1.1-million today, give or take a few bucks.

Which is precisely why he can sell a vastly - some might say absurdly - overpriced public offering.

This assessment should not be construed as a bearish call on energy and gold, the firm's favourite investment themes, nor as doubting Mr. Sprott's genius, which is obvious. Actually, the second part is important; since he is smart, and since Sprott Inc. is his baby, you have to presume that he has carefully chosen the moment to sell.

Why should Sprott, the firm, go public at all, with all the scrutiny (and sharing of the profits) that comes with that? It doesn't need money. It isn't getting money. All of the stock in the estimated $200-million deal is coming from insiders. When the executives in an existing public company sell shares on a large scale, we raise our eyebrows and wonder why. When they do it through an IPO, we glorify it.

There are plenty of solid reasons to sell besides the fact that you can get a fat price, of course. Mr. Sprott is 63. A public listing, we're told, will be useful for attracting new talent and for passing the torch to the next generation. A lot of money-management firms have figured out how to do this while remaining private, though.

Still, the fact that insiders are selling does not necessarily imply heartache for the buyers. So what other danger signs exist? In this public offering, we emphasize the word "public," for the Sprott sale is, apparently, being very warmly embraced by retail brokers and their customers.

Whenever you combine (a) large numbers of retail investors with (b) a shrewd seller, with an asset that is (c) trendy, hyped or hot, you have created a dangerous mix. The Sprott deal may be the best example of this we've seen in Canada since the Tim Hortons IPO three years ago. Heavy buying from the retail audience drove the stock up to $37 on the first day. Now it's $32.71, even though profits continue to go up.

Doughnuts, hedge funds - the principles of investment remain the same. Good stock picking means not only buying a company with sound economics - which Sprott is - but buying at a sensible price as well. How do you know what's rational for a business that's growing this fast? Sprott's revenue has increased sixfold in just four years, to $237-million in 2007. More than half of that came from performance fees on Sprott hedge funds, because the firm had an outstanding year.

There lies the key. Performance fees, of course, depend on the funds' returns, and yes, even Eric Sprott has a subpar year once in a while. All investors do. In 2003, for example, performance dropped and the firm's revenue plunged by 45 per cent. When commodities markets turn, it's possible - likely, even, given Sprott's heavy concentration in small-cap energy and mining companies - that performance fees will be non-existent for a year or two.

The best way to look at Sprott, then, is as two separate companies. The first part includes the base management fees, which are steady. The company earned $49-million last year in EBITDA on those, after some adjustments; valuing those earnings at 10 times seems appropriate, even though most fund companies trade for less. But call it $500-million.

Now to the performance fees. Sprott made $97-million in EBITDA last year from these, but as we've noted, it was an exceptional year. This profit stream will be volatile; indeed, two years earlier, it was only $16-million. So it doesn't make sense for an investor to pay anywhere near the same price for this as he'd pay for the base fees. Say, five times EBITDA? That's another $500-million.

Our conclusion: $1-billion might be fair value for Sprott, though even that might be generous. (Gluskin Sheff, a similar firm that's nearly as large, has a value of $800-million.) And the price at which Sprott is being offered to the grateful and adoring public? Try $1.5-billion to $1.6-billion.

No disrespect to Eric Sprott: The guy's a sharp investor - sharp enough to know when people will pay 50 or 60 or 70 per cent more for his company than it's actually worth. You'd ring the cash register, too, if you were him. It has been nearly impossible to lose money on anything he's associated with. Until now.