Genworth MI Q4-2014, Canadian housing market

Genworth MI (TSX: MIC) reported their Q4 results a couple days ago. This report was a little more interesting than previous ones simply because there has been a relatively large shift in sentiment concerning the Canadian housing market due to the collapse in crude oil pricing (and its impact on Alberta and Saskatchewan).

The actual result was less relevant than the future guidance of the company.

Specifically, the guidance was that the loss ratio anticipated in 2015 would be between the 20-30% range, while the long-range guidance was for a loss ratio of 30-35%.

As I have pointed out on multiple occasions, the loss metrics for Genworth MI over the past couple years has been extraordinarily favourable, with the pinnacle of loss ratios in Q2-2014 of 12%. Q4-2014 was moderate, with 26%.

Cited was the economic slowdown in Alberta, but they appear to have a fairly solid grip on the upcoming cataclysm that will be occurring to employment in Alberta and Sasketchewan. Approximately 27% of the insurance written in 2014 was in Alberta, although 17% of the insurance in force is from the province.

By virtue of the fact that zero-down loans are no longer done, direct comparisons to 2008 would appear to be less muted, although there will obviously be an increase in losses coming in 2015 from Alberta and Saskatchewan for the company. The question is how bad they will be.

That said, the company still has an incredible amount of room to maneuver with. Their loss ratio for fiscal 2014 was 20% and expense ratio of 19%.

Realize accounting-wise that all of their cash is collected up-front and then revenues are recognized according to a financial model that allocates premiums written (deferred revenues on cash received) to actual revenues (removal of deferred revenues). The revenue recognized is not cash. Instead, the company must earn cash on future premiums collected (somewhat pyramid-schemish!) but also the receipt of investment income.

Investment income is obtained through a portfolio that is 41% corporate debt, 49% government debt, 3% equity and 2% asset-backed bonds, and the remainder 5% is cash and short-term cash equivalents. The total value of this portfolio is $5.4 billion earning an investment yield of approximately 3.5% and a duration of 3.7 years. As interest rates continue to plummet, this investment yield will likely decrease (although they do have a good chunk of unrealized gains due to the rate drop). Reinvestment will become continually a higher challenge for this insurer and many others.

Investment income for the year was $195 million.

In terms of book value, they ended the year approximately at $35.12/share according to my calculations.

Valuation-wise, they are somewhat below my fair value estimate, but not at the point where I would buy more shares. Market sentiment may take them further down and if it does so, I may consider adding to my position. The company itself may decide to repurchase shares (at a much better price than its previously botched buyback of 1.87 million shares at CAD$40/share) which I would approve of simply because repurchases would cause book value to increase. The company holds a minimum capital buffer of 220% over the regulatory requirements (currently at 225%) and they have indicated that they will hold a modest amount of capital above this percentage. I suspect the majority of excess will go towards a share buyback later in the year.

If the company streamed off its entire net income to dividends, they would be giving a 12% yield at present.

I generally do not believe that there will be a precipitous collapse in the Canadian housing market unless if there is an overall recession that affects more than a single commodity industry. In addition, most equities that I see that have significant exposure to Alberta’s economy are trading significantly lower than they were half a year ago. I do have a name in mind (below book value as well) when I write this, but my inability to predict when Alberta will get “hot” again is not assisting with an investment decision.

Government bond yields indicative of a very ill market

If we are in the Japan-like scenario of what happened after 1989, it would suggest that we will be seeing very choppy equity markets over the next decade (this includes up and down swings of 40% or so over multi-year periods, just look at the Nikkei index) and one should wrap their heads around the ability to make money in the marketplace when the overall indicies are not moving in the long run. Some basic financial theory would suggest that if the market gives equities a modest 2-3% risk premium, the most we will be seeing out of the S&P 500 on an annualized basis is around 4-5% nominal returns. The ultra-low bond yields we are seeing internationally are also a symptom of huge problems.

As a small factoid, Canadian 10-year debt is at 1.3%. Looks relatively attractive when comparing it to Japan’s 0.38%, Germany’s 0.37%, or the wonderfully fantastic -0.1% yield you’ll get by buying Swiss Government 10-year debt.

Smarter people than myself have already figured out that one of the primary arguments against gold is that it has no yield. But gold looks very attractive when viewed in relation to either sitting on a pile of Swiss paper (literally Swiss Francs underneath the bed mattress) as you wouldn’t want to be investing your money in negative-yield debt. At least when your house catches on fire, the gold is reclaimable.

Once all the gyrations in the fossil fuel market work their way through, having a swimming pool of crude oil in the backyard isn’t going to hurt either.

The new norm is going to be increased volatility

There are a lot of gyrations going on right now with central banks jockeying for position and a certain amount of dysfunctionality out there. The new normal is increased volatility than the relatively calm times in the middle of 2014:

vix

Other than the direct purchase of VIX futures (or the VIX ETF, the most liquid of which is VXX), one must think about companies out there that can take advantage of volatility.

Connacher recapitalization

Connacher Oil and Gas (TSX: CLL) announced late last week a recapitalization plan. In exchange for CAD$350 and USD$550 million of second-lien notes (behind $144 million in first-lien notes and an operating facility), Connacher will give 98% of the equity to the second-lien noteholders. 70% of the noteholders are apparently on board with the proposal.

The noteholders will also have the right to subscribe to another $35 million of second-lien notes.

The company also announced its 2015 projections at WTIC US$49.75/barrel, and it is not pretty: $76 million in losses projected.

Assuming the recapitalization succeeds, shareholders are looking at a 50x dilution of their holdings. The alternative would simply be a zero so there is some value left in the equity.

Clearly the company is uneconomical with existing oil prices and if existing prices continue for the next few years, the company will likely get into financial trouble once again. Not for the faint of heart.

Connacher has a soft spot in my financial heart as their convertible debentures were something I invested in the middle of the financial crisis. They were at around 30 cents on the dollar and I got out in the 90’s a year or two later. They eventually did get redeemed at par on maturity. I have no positions presently.

Fast Food – Signs that a corporation is in trouble

Whether it’s Tim Hortons (TSX: THI), Wendy’s (NYSE: WEN), Starbucks (Nasdaq: SBUX), etc., fast food is a big business. There are winners and losers and the game is mostly zero-sum. Finding the losers at any point in time is much better than finding the winners – at least you’ll know who to avoid.

The most recent trend that I can discern in the industry is the trend toward customization and “quality” fast food. Specifically the winners of the new tastes in customer trends appear to be corporations like Chipotle Mexican Grill (Nasdaq: CMG) that, judging by their $700/share price and $22 billion market valuation, have valuations that are trading in the stratosphere. It hit the magic formula by going for a territory that was previously covered by independents (mainly the truck-side stands in the USA where you can get a good burrito for a few bucks made by actual Mexicans of unknown immigration status), “quality” (just observer all the health propaganda about organic this-and-that), and customization (e.g. this Youtube video of some guy visiting an international franchise in London, England is a fairly good example). Results: the hopes and dreams of short-sellers crushed into oblivion. (Just pull up the rocket ship known as a 5-year chart of CMG and you will see what I mean – they’ve done twice as well as Amazon!).

Franchises like Five Guys and Fatburger are all in the same zero-sum space for burgers, which is a much more competitive environment. You also have Burger King (going through the pains of integration with its Tim Hortons merger), and you have McDonalds.

However, this post was not about the winners, it is about the losers.

And that, for today (and definitely not for tomorrow), is McDonalds.

My attention was swayed by a very brief Marketwatch article about their new marketing campaign, and specifically the following:

McDonald’s released its 2015 Super Bowl ad which spins off the long-running “I’m lovin’ it” campaign. The ad shows customers ordering food. When the cashier rings them up, the cashier ask customers to pay by an act of love rather than cash.

The “Lovin’ Act” extends beyond your TV screen and to actual restaurants. Between Feb. 2 and 14, randomly selected customers will be asked by each store’s “Lovin’ Lead” to execute an act subject to the lead’s discretion. 100 customers per store will be chosen to win throughout the duration of the promotion.

The amount of cultural damage that must be going on in McDonald’s at the moment to allow such a marketing campaign to hit the public must be immense. They already recently fired their CEO (a positive step) and hopefully once the marketing people have had a chance to analyze what a disaster this campaign is going to be, they will actually settle down and concentrate on what they were always supposed to be good for: reliably inexpensive fast food. Maybe by firing their marketing team that conceived of their last campaign, they can save on future costs.

Those familiar with the history of fast food companies will remember the similar slump McDonalds went into 2001-2003 where they finally snapped out of their dementia. Other fast food chains have gone into similar states over the past decade, notably Domino’s Pizza’s (NYSE: DPZ) mea culpa confession that its product tasted like cardboard, and Howard Schultz coming back to Starbucks to get the corporation to realize that people came to Starbucks for coffee and not breakfast or lunch sandwiches.

Interestingly enough, I think Wendy’s is also executing correctly on a turnaround and is eating McDonalds’ lunch. I’ve been eyeing them back since early 2014 and while I am very unlikely to purchase any common shares at current values, I do find this space to be fascinating from a business and marketing perspective.

The easy trade is rarely the best one

Canadian Oil Sands (TSX: COS) had a wild day after their year-end report and upcoming projections for 2015.

2015-01-30-COS.TO

Traders clearly were panicked at the beginning of the day and when they all cleared the exits, the stock rocketed upwards.

The amount of volatility we are seeing in the Canadian oil and gas sector is indicative of the volatility typically seen in down points in the market (see 2008-2009 for a good example of this), but these scenarios typically take months to finish and not days. Of course you have to be there exactly at the day the S&P 500 hits 666 in order to catch the absolute bottom, but the right trade at the time should feel painful.

Right now buying into oil seems like the right thing to do, but the trade doesn’t feel painful to make. This makes me very cautious and I will continue to wait.

The other item I am looking for is that audited financial statements are due on March 31st, although companies typically report them earlier. Loan covenants are going to be tested against these numbers and it will be obvious which players out there will be over-leveraged.

The other comment I will make is that most producers seem to be in a waiting game – even Canadian Oil Sands projects a WTIC price of US$55/barrel in their 2015 overall projection. Right now WTIC is at US$47 (the December 2015 crude future is at US$56) so we are not too far off that projection, but the financial modelling of all of these companies (and even the Government of Canada) has an upward bias to commodity pricing. What if this doesn’t materialize? As company hedges (note that COS does not engage in hedging) start to expire and companies have to really start digging into their balance sheets to remain operating at existing production levels, eventually you’re going to see production decreases. Only until then it seems the fundamentals will sufficiently shift toward higher oil prices.

The trade at that time, however, will be painful. Only then will investors see a superior reward on their investment.

The same applies to currency markets. Right now going against the US dollar seems like stepping in front of a freight train at full speed. I’ll be unwinding some US currency exposure if the Canadian dollar depreciates a little more.

Inverted yield curve

The Canadian bond market is exhibiting a very minor instance of an inverted yield curve between short term and 2-year money. You can view interest rates here.

This is a good an indication as any that we’re going to touch upon a zero GDP growth cycle coming later in 2015 and perhaps negative. Pull out the textbooks to see what industries are good to invest in a recessionary climate.

Canadian dollar

The Canadian dollar crossed the USD/CAD 0.8 (reciprocal 1.25) mark for the first time since the economic crisis. Part of this was a sudden reaction down to the US Federal Reserve’s statement basically saying they are waiting and seeing.

cdw

Eventually there will be a time to shift out of US currency and into Canadian dollars, but now does not feel like the right time.

Last second agreement with Pinetree Capital

I thought Pinetree Capital was going into CCAA, but clearly there was enough arm-wrestling behind closed doors to come to the following agreement (which should hopefully be posted in SEDAR fairly quickly):

In connection with the execution of the Forbearance Agreement, each of Messrs. Roger Rai, Sheldon Inwentash and Marshall Auerback will resign from the board of directors of the company. As well, Mr. Inwentash will resign as Chairman and CEO of the company. Richard Patricio, the company’s Vice-President, Corporate and Legal Affairs will assume the responsibilities of Interim CEO.

Management is gone, plus three (of seven) directors, all of which can be considered to be heavy insiders in the company. Needless to say, considering past performance, this can only be a plus.

The CFO and corporate counsel is still on board, presumably to keep continuity in the overall operation.

I had speculated in my earlier post that the reason why Pinetree did not come to any agreement with debentureholders was because they demanded that management be removed, and it looks like management blinked. The reason for this is perhaps because they did not want to be associated with an entity going into creditor protection. This has to get disclosed in any subsequent documents (such as annual information forms) if management is associated with any publicly traded entities.

the Supporting Debentureholders will have the right to nominate up to three directors to the company’s board of directors; two of whom will constitute an investment oversight committee to be established by the company;

The current board (including the three directors that will be leaving) is of seven people; while this is minority representation, one can presume that they will bring in actual investment expertise to ensure that the interests of the debtholders are respected in future decisions. In particular, the hiring of a new CEO will be the most important decision the reconstituted board will make.

the company will grant security over its assets in favour of all holders of the Debentures;

This will ensure that debenture holders will receive proceeds of any sale of the company, including the value of the deferred tax assets. It will also restrict the company from borrowing more money unless if subsequent lenders understand they are subordinated.

the company will utilize at least $20 million to reduce the aggregate principal amount of the outstanding Debentures by July 31, 2015, and will be subject to a debt-to-assets ratio of 50% (in lieu of 33%) for the three-month period of July through September;

$20 million will be utilized and whatever discount there is to market value will result in a higher par value retired by the corporation. At the current quotation of 70 cents, this would retire about $28 million in par value, or about half the current issue.

the Indenture will be amended to remove restrictions on the company’s redemption rights, subject to the approval of the Toronto Stock Exchange; and

I am not entirely sure what this alludes to, but we will see whenever the agreement is posted on SEDAR.

the trustee and the Debenture holders will refrain from exercising any rights or remedies that they may have against the company under the Indenture or otherwise, as a result of the current default and any subsequent default in respect of the Covenant occurring up to October 31, 2015.

This is functionally a 9 month grace period. The maturity of the debentures is May 2016.

You will have the debtholders working to ensure an efficient liquidation of assets coupled with the possibility that they might end up with a significant equity stake if there is a redemption to equity on the May 2016 maturity. The October 31, 2015 restriction is designed to ensure that debtholders have effective control of the company if Pinetree’s debt-to-asset ratio is not less than 33% by October 31, 2015.

Some remaining questions:

1. Will Pinetree be able to liquidate its holdings efficiently? Reported NAV was 46 cents in November 30, 2014.
2. Final year-end statements must be received and filed publicly by March 31, 2015. At a minimum, it will probably look like their $13 million in deferred tax assets will be vanishing and a valuation allowance put into place. The level 2 and level 3 assets will have to be carefully examined to see if they are worth anything (this was $55 million of the reported $161 million in assets at the Q3-2014 statement).

Finally, the asset remaining on the books that is not going to be seen on the statements will be the half-billion dollar capital loss tax shield. This will get sold, the question is for how much and to who. You would think that the debtholders, compromised mainly of financial firm people, will have a way of getting this into one of their own closed end funds for utilization – funds that generate capital gains to offset such losses.

Currently the equity is getting trashed (at 7 cents per share, down from 11 cents when it was halted), while the debentures are roughly level. My initial suspicion would be that with the removal of management, you would have an increase in valuation, but I guess I was wrong there too.

That’s about it for Pinetree Capital

History: Pinetree Capital previous postings (link here).

January 23, 2015 was the date that Pinetree Capital (TSX: PNP) had to cure a covenant breach of its debt-to-assets ratio (being 33% or less). Unfortunately for them, they failed to obtain a waiver or apparently cure the default.

Before the ordinary time of opening, IIROC put a trading halt with news pending. There hasn’t been any news published so it would lead one to believe that management has failed to cure the breach.

Section 8.1 of the indenture states:

ARTICLE 8
DEFAULT
8.1 Events of Default

(x) in each and every such event listed above, the Trustee may, in its discretion, and shall, upon receipt of a request in writing signed by the holders of not less than 25% in aggregate principal amount of the Debentures then outstanding, subject to the provisions of Section 8.3, by notice in writing to the Company declare the principal of and interest on all Debentures then outstanding and all other monies outstanding hereunder to be due and payable and the same shall thereupon forthwith become immediately due and payable to the Trustee.

One can presume that given the rather speedy notice that was given to the company of the default that the trustee is going to get notified of this breach fairly quickly and on the first business day, January 26, 2015, the principal and interest will become due immediately. Since there is an event of default occurring, the company cannot trigger the common share conversion feature.

My guess at this point is that the trading halt will continue until Pinetree officially declares itself unable to pay its debenture and goes into CCAA. Then TSX rules will suspend trading and eventually delist the company. The subsequent proceeding will involve the bankruptcy trustee being instructed by its creditors (the bulk of which are the debenture holders of which the major players will form a committee) to liquidate and put an end to the terminally ill patient.

My other observation is that Pinetree Capital management should have received the hint back in 2013 that they needed to reduce debt by purchasing debentures off the open market while they were given a 9-month grace period by its debtholders. They instead went recklessly purchasing other penny stock securities and ultimately got what they deserved.

My other guess is that behind the scenes the debtholders told management the only condition they will accept for a waiver is a complete overhaul of the board of directors and management. Clearly management did not agree, nor is it in management’s best interest to re-capitalize their company with fresh equity (i.e. cash) since this cash would most likely end up in debtholders’ hands.

I originally thought management had better self-preservation instincts, but apparently even this was too much for them to handle.

Skimming their last quarterly report (September 30, 2014), we have the following entry:

For the nine months ended September 30, 2014, the Company generated net realized losses on disposal of investments of $334,412, as compared to $14,921 for the nine months ended September 30, 2013. The net realized losses in the current period was a result of the disposition of approximately 68% of the Company’s investment portfolio.

Realize these numbers are in the thousands, so just in the first nine months alone they managed to go through 1/3rd of a billion in realized losses (a lot of which I am sure have been on their books for ages). They also have another $118 million in unrealized losses their portfolio, which will inevitably get liquidated for less than fair value as stated on their financial statements.

My idea for Pinetree’s inevitable exit strategy was that they would sell their corporation off to some hedge fund actually capable of making money. The acquiring fund could use Pinetree’s accrued capital losses as a massive tax shield. There are quite complex rules concerning CCAA (if things get there) and utilization of operating and capital losses that I will not get into this post about, but suffice to say, my original idea for their exit strategy has not materialized.

Somebody give me management’s $1 million a year salary job and I’ll do better, I promise. Heck, I’ll do it for a 10th of that with a bit of an equity incentive.