Paradigm Research makes right call on Magellan

Whenever a CEO mutters about a crappy share price, the best advice is always the same: “take care of the business and share price will take care of itself.” In a research note from earlier today, Paradigm Capital’s analyst went to great lengths to make this point about Magellan Aerospace (MAL:TSX), without ever having to revert to the cliche.

Here’s the note. It’s a courageous call, and they should be commended for it. Murray Edwards is a powerful man in many corporate finance circles, and telling him that he’s wrong isn’t for the faint of heart. Investment banking is, after all, a business. And the issuers pay the bills, not the buyside:

Magellan Board Proposes a 5:1 Share Consolidation and Fundamental
Improvements

In the proxy circular sent to shareholders, the Board of Magellan is asking shareholders to vote on a proposal to consolidate the shares on a 5:1 basis. We believe this tactic will not improve shareholder return.

• The Path to Share Price Appreciation is Profitability Not Share Price Cosmetics

We would underscore that the key to having the shares appreciate in price is to return the company to profitability. It has been a difficult and long trough in the aerospace cycle, especially for Canadian companies and we are not through the bottom yet. In our view, consolidating the shares will not mask the difficulties facing the company and the investors will not be duped into paying more for the company.

• Share Liquidity Will be Severely Reduced

Magellan currently has 90.0m shares issued and outstanding. Hence a 5:1 consolidation would reduce the number of shares outstanding to 18.2m shares.

Free Float Would be Decimated

Murray Edwards through Edco Financial Holding Inc. owns 27.8% of the current shares outstanding. Hence the free float under the consolidation would be reduced to 13.1m shares outstanding.

• Higher Share Price Will Cause More Shorting

A higher price per share could cause more shorting of the shares driving the share price lower after the consolidation.

• Expect the Shares to Fall to $0.60 Equivalent if the Shares are Consolidated

In our considered view, based on much experience in the Canadian capital markets, we believe the shares could drop to the $0.60 level on an equivalent basis if the share consolidation is allowed to proceed. This is based on the following factors:

???? Expect retail to unload positions, as the historical experience of consolidations is for severe share price underperformance (ie. Nortel)

???? Exhaustion selling as investors view this maneuver to be a “house of cards” tactic.

???? Short sellers enter the picture in an aggressive manner.

Recommendation Fix Fundamentals Not Share Count

Generally there is the view that share splits are positive for stock prices while share consolidations are negative. While empirical studies indicate they should have no impact, our experience has proved otherwise. We believe, however, the reason for the moves up (split) or down (consolidation) has more to do with improving (split) or deteriorating (consolidation) fundamentals. This is what is really important. If Magellan is successful at improving its balance sheet, and executing a fundamental turnaround, including a return to profitability, we believe the share price will take care of itself and appreciate without the need for a share consolidation. The power is in the hands of the shareholders, both institutional and retail as management controls only 27.8% of the shares. As we have outlined above there is in our view no upside to shareholders in consolidating the shares.

The idea that a higher share price will give the shares more attractiveness is erroneous as the most important consideration is to improve the fundamentals of the company. Altering the share count cannot mask the importance of profitability improvement.

Magellan shareholders can only hope that PMs across Canada will take note and vote this proposal down at the upcoming annual general meeting.

If they don’t, this moment in time will serve as the starting gun in the eventual going-private of MAL by its major shareholder.

MRM