Teranet's monopoly worth holding onto

It's a fabulous business, and as a shareholder it warms my heart to know that someone is paying me while I sleep at night.

By Kevin O'Leary
Globe Investor Magazine Online, November 10, 2008

Kevin O'Leary is the chairman of Gencap Funds LP, the manager of the O'Leary Global Equity Income Fund and the co-host of BNN's Squeeze Play

Before you read on, know this.
1) I am a Teranet shareholder and I am greedy.
2) I tried to buy the company myself before it was taken public as an income trust.
3) I am intoxicated by the beauty of this company's business model; it's a monopoly and the closest you will get to perfection when it comes to an investment.

I don't own Teranet shares in the O'Leary Global Equity Income fund; I own them personally. With these disclosures out of the way, let me tell you why I am not tendering my shares tonight for $10.25 into the Ontario Municipal Employees Retirement System/Borealis Infrastructure offer. I'll tell you what I know and you can make up your own mind as to what to do with yours.

Teranet is the electronic land registry for the Province of Ontario. Every time there is a real-estate transaction in the province, Teranet gets a fee. It does not matter if the price of land goes up or down; every time there is a real-estate trade, Teranet gets paid.

It's a fabulous business, and as a shareholder it warms my heart to know that someone is paying me while I sleep at night. The company built this proprietary database by painstakingly scanning every land parcel that makes up the province of Ontario into digital form. It took decades and cost hundreds of millions of dollars to do this, but there are a finite number of land parcels to scan and some time next year Teranet will have scanned them all.

So very soon this fantastic business will get even better. The company will no longer have to pay the heavy cost of scanning parcels and will move into the "harvest" mode of this database. This is the ultimate infrastructure play: If you are a shareholder you get paid and paid and paid.

I first met the Teranet management when I was part of a private equity syndicate that tried to buy the company. At that time, we were competing against the sizzling hot income trust market. Ultimately, we were unable to even come close to the valuation that Teranet would trade at as an income trust, and the company rejected our offer and went public instead. I became a shareholder in the IPO and have been clipping coupons ever since.

Over the last few years there have been many discussions amongst private equity firms and pension funds about Teranet. Many friendly offers have been informally discussed with the company, but nothing gelled until Borealis put the company into play with an offer of $11 a share. The company set up a data room and over a dozen interested parties came to the table. When no other offer materialized, OMERS immediately dropped their offer to $10.25 a share. It was the smart move.

So if the business is so great, why are there no other offers? First, typical private equity players need debt to make a deal work and the debt markets are dead. So it's almost impossible to mount a competing all-cash bid. The other problem is political. When you operate Teranet, you are in partnership with the government of Ontario, not in equity ownership, but in determining prices you can charge.

Many investors have elephant-like memories and remember the 407 litigation. That was not a pretty time in public-private relations in the province of Ontario, and that may have muted the desire of other players to get involved in a similar situation like Teranet.

There is something else you should know about Teranet. Aris Kaplanisv, Teranet's CEO, and his team have been quietly building new lines of business and services that they can sell to their captive user base.

Prices for their new offerings are not regulated by the government. Currently, these are about 12 per cent of Teranet's cash flow but they are growing like wildfire, over 50 per cent annually. I'm not telling secrets out of school. The company has been pounding the table about these new opportunities but no one is listening.

Borealis is owned by OMERS, the pension fund. The CEO there is Michael Nobrega. Michael and I go way back. He was on my board at SoftKey Software Products, a company I started in the early 1990s. We built a wonderful business together, and eventually sold it to the Mattel toy company for $4.2-billion in 1999. Michael Nobrega is a very tough negotiator, and when it comes to numbers you will not find a smarter man.

But it is his patience that is legendary. Michael and I and a few other friends once made a venture investment in a small business services start up. As often happens in startups, things did not go well and I eventually wrote the investment off. But not Michael - he personally worked the deal for another year, eventually getting all his partners' capital back. When it comes to money, I never forget.

Now as a Teranet shareholder I find myself on the other side of the table from my old friend. He wants to buy my shares for $10.25 and we both know they are worth at least $12.50. I am not a large enough shareholder to block this deal but I hope others vote as I will.

Infrastructure players like OMERS and Macquarie Capital Markets buy assets that return 7 per cent and 9 per cent all day long. In terms of stable cash flow, monopolies like Teranet are as good as it gets. If you apply a hurdle of a 7-per-cent return and depending on what you assume for capital expenditures (remember the big cap-ex costs of scanning are about to end), you can pay $13 a share and easily make 7 per cent annually in perpetuity.

What is the likelihood that this deal does not happen? Very low. Money managers are hurting. Redemptions are at historic highs and they need liquidity. Along comes a deal like this and they can get badly needed cash.

I would prefer to be patient, let Teranet's management build the business and wait for a better offer to come along when markets get better. Remember, it's a monopoly you are invested in and they don't come along every day