A very quiet May and some self-reflection

It has been a relatively calm month of May for me – I know the cliche of sell in May and go away has resonated in my mind, but my positioning is still quite defensive (very heavily weighted in preferred shares and corporate debt). One advantage of such a defensive portfolio structure is that it is relatively insulated to equity volatility.

The past three months have seen quite a significant performance gain and when there are gains this large I always ask myself whether it is sustainable. When I look at the fixed income components of my portfolio, I see higher room for appreciation from current levels as markets continue to normalize. For whatever reason, Canadian markets were heavily sold off in early February, especially in the fixed income space, and we are still continuing to see a normalization of these valuations.

There were a few missed opportunities on the way. I will throw out a bone for the audience and mention I was willing to pounce on Rogers Sugar (TSX: RSI) when it was going to trade below $3.75/share, but clearly that did not happen (sadly, its low point was $3.84/share) and it has rocketed upwards nearly 50% to $5.71 presently on the pretense that Canadians are going to have a sweeter tooth for sugar rather than corn sweeteners in the upcoming months (which is true – their last quarterly financial statements show an uptick in business and this should continue for another year or so and the market has priced this in completely).

My overall thesis at this point is that the aggregate markets will be choppy – there will not be crashes or mega-rallies, but there will be lots of smaller gyrations up and down to encourage the financial press that the world will be ending or the next boom is starting. When looking at general volatility, the markets usually find something to panic about twice a year and we had a large panic last February. The upcoming panic would likely deal with the fallout concerning the presidential election.

If net returns from equity are going to be muted, it would suggest that the best choices still continues to be in fixed income. The opportunities at present are not giving nearly as much of a bang for the buck in terms of risk/reward, but there are still reasonable selections available in the market. A good example of this would be Pengrowth Energy debentures (TSX: PGF.DB.B) which is trading between 94 to 95 cents of par value. Barring crude oil crashing down to US$30/barrel again, it is very likely to mature at par on March 31, 2017. You’ll pick up a 6% capital gain over 10 months and also pick up some interest at a 6.25% coupon rate. Worst case scenario is they elect a share conversion, but with Seymour Schulich picking up a good-sized minority stake in the company, I very much doubt it. (Disclosure: I bought a bunch of them a couple months ago at lower prices).

In the meantime, I am once again twiddling my thumbs in this market.

Reviewing one of my year-end predictions

For my December 31, 2015 new year’s predictions, I said the following:

* Next US President: Donald Trump will be elected as the next president of the United States, by a considerable margin. This prediction is not an endorsement of him, but it is a reflection of my political analysis and my take on what is happening in the United States at present.

I’ve been telling people since September 2015 that Donald Trump would not only win the nomination, but the presidency of the United States. The general election result is not even going to be close – Trump will get at least 350 electoral votes.

Best places to park short-term, nearly-risk free Canadian cash

As a result of the Bank of Canada’s decision to hold the overnight interest rate target at 0.5%, options for Canadian dollar cash balances are bleak.

Cash can always be held at zero yield and would be immediately available for deployment.

There are also financial institutions that will allow you to lock your money in for a 1-year GIC and earn around a 1.25% risk-free return. However, the sacrifice in liquidity in the event that you would want to deploy such capital is unacceptable from an investment perspective. One can also purchase a cashable GIC (typically redeemable within 30 days after purchase) that earns slightly less yield – my local BC credit union offers such a product with a 0.85% yield.

I was curious as to the best exchange-traded products that would offer some yield at the lowest risk.

There are basically two options. They are (TSX: XSB) and (TSX: VSB). Both are short-term government bond funds. VSB is significantly cheaper on management expenses (0.11% vs. 0.28% for XSB), and both portfolios offer similar durations (roughly 2.8 years), and VSB has slightly better credit quality (55% weight to AAA instead of 50% for XSB). VSB should eventually have a better net yield after expenses (roughly 1.1%) due to the smaller MER. While the 1.1% net return is small, it is better than zero and is nearly risk free – there is anti-correlation between general market movement and the likely price movement of this fund – the capital gain on VSB should rise if there was some sort of crisis due to the heavy government bond exposure of the fund.

Another alternative which is deceptively cash-like but will not serve any purpose if you wish to save money for some sort of financial crisis is the high-quality corporate bond fund also offered by Vanguard (TSX: VSC). Although VSC will offer you another 80 basis points of yield, it has the disadvantage of likely having a liquidity premium in the event there was some adverse financial event – i.e. your cash-out price will likely be materially less than NAV.

All three ETFs trade at modest premiums to NAV.

Bombardier update

It is virtually a given now that Bombardier will announce that Delta Airlines has ordered a bunch of C-series jets. The announcement will probably be Thursday as there is no reason for them to move back the earnings announcement unless if they want to have a huge feel-good party for their annual general meeting on April 29th.

However, in terms of pricing of securities, “buy the rumour, sell the news” is the cliche to follow here. Most (if not all, or even an over-reach) of this news has been baked into current market pricing, which means that investors will now have to focus on the finer details, such as: how much of a price concession did Bombardier make in order to ink the sale on the contract?

These price concessions inevitably will affect profitability of the overall entity, and while it is nice to sell jets at a near break-even profit margin, the corporation needs to eventually make money.

However, Bombardier has solved one of their massive problems which was a chicken-and-egg type matter: they now have an American purchaser of their jets, which is a lot better than how things were portrayed for them half a year ago. More importantly, they are current in a position to raise capital again from the public marketplace.

I will point out in a reduced profit scenario that the security of income from the preferred shares (or even the bonds) looks more favourable from a risk-reward perspective than the common shares. Back in February, investments were selling preferred shares (the 6.25% Series 4) at 18% yields, but today it is at a much more respectable 10%. I’d expect this to get around 7-8% before this is done.

My investment scenario is pretty much resolving to my initial projections – just have to continue to be patient and then the decision is going to be whether I sell and crystallize the gain, or just be content to collect coupons and sit on a large unrealized capital gain.

(Update, April 28, 2016): As expected, Bombardier has announced that Delta has purchased 75 C-Series jets with an option to pick up another 50. This is a huge win for the corporation, but again, the question remains: how much money will they actually be able to make when they produce these things? Let’s hope they’re able to actually get the production lines going and crank them out without issues, unlike their Toronto street cars…

I’ve glossed over their Q1-2016 financial statements, and as expected, they still show an entity that is bleeding cash, albeit they have a lot of liquidity available – US$4.4 billion in cash and equivalents when you include Quebec’s $1 billion investment. They’ve got US$1.4 billion due in 2018 on their March 2018 debt (coupon 7.5%) but this is trading at around a 6.5% YTM at the moment so they can refinance it.

The company expects the C-series program will consume $2 billion further cash for the next five years, of which the province of Quebec has generously chipped in a billion. After that they expect things to be cash flow positive. Who knows if this will happen!

(Update, April 29, 2016) The market has “sold the news” as I expected. I generally believe the common shares will have a significant drag compared to the historical charts due to dilution, but the preferred shares and debt should normalize to “reasonable” yield levels simply due to their standing being in front of line on the pecking order. This is assisted with the Beaudoin family’s very rational self-interest in maintaining their control stake with the Class A common shares which will translate into outwards cash flows being paid as scheduled. If the Government of Canada decides to chip in a billion dollars, it is icing on the cake, but it is not required as Bombardier will be busy for at least the next four years producing C-series jets. Assuming they can actually execute on the production and the jets live up to their reported (superior to competition) specifications, they should be good to at least pay off debts and preferred share dividends.

Each additional order of C-Series jets will be making profitable margin contributions and as these orders continue to come in, the common shares, preferred shares and debt will ratchet up, accordingly. I still believe they are under-valued but not nearly as much as they were late last year when everybody was in doom and gloom mode! The preferred shares are the sweet spot in terms of risk-reward.

Teekay Corporation – Debt

Over the past couple months I have accumulated a substantial position in Teekay Corporation’s (NYSE: TK) unsecured debt, maturing January 15, 2020. The coupon is 8.5% and is paid semi-annually. I am expecting this debt to be paid out at or above par value well before the maturity date. The yield to maturity at my cost I will be receiving for this investment will be north of 20% (and obviously this number goes up if there is an earlier redemption).


I was really looking into the common shares and was asleep at the switch for these, especially around the US$7-8 level a month ago. Everything told me to pull the trigger on the commons as well, and this mistake of non-performance cost me a few percentage points of portfolio performance considering that the common shares are 50% above where I was considering to purchase them. This would have not been a trivial purchase – my weight at cost would have been between 5-10%.

However, offsetting this inaction was that I also bought common shares (technically, they are limited partnership units) of Teekay Offshore (NYSE: TOO) in mid-February. There is a very good case that these units will be selling at US$15-20 by the end of 2017, in addition to giving out generous distributions that will most likely increase in 2018 and beyond.

The short story with Teekay Corporation debt is that they control three daughter entities (Teekay Offshore, Tankers, and LNG). They own minority stakes in all three (roughly 30% for eachUpdate on April 26, 2016: I will be more specific. They have a 26% economic interest and 54% voting right in Teekay Tankers, a 35% limited partner interest in Teekay Offshore, and 31% limited partnership interest in Teekay LNG), but own controlling interests via general partner rights and in the case of Tankers, a dual-class share structure. There are also incentive distribution rights for Offshore and LNG (both of which are nowhere close to being achieved by virtue of distributions being completely slashed and burned at the end of 2015). If there was a liquidation, Teekay would be able to cover the debt with a (painful) sale of their daughter entities.

Teekay Corporation itself is controlled – with a 39% equity stake by Resolute Investments, Ltd. (Latest SC 13D filing here shows they accumulated more shares in December 2015, timed a little early.) They have a gigantic incentive to see this debt get paid off as now do I!

The mis-pricing of the common shares and debt of the issuers in question revolve around a classic financing trap (similar to Kinder Morgan’s crisis a few months ago). The material difference that the market appears to have forgotten about is that Teekay Offshore (and thus Teekay Corporation’s) business is less reliant on the price of crude oil than most other oil and gas entities. The material financial item is that Teekay Offshore faces a significant cash bridge in 2016 and 2017, but it is very probable they will be able to plug the gap and after this they will be “home-free” with a gigantic amount of free cash flow in 2018 and beyond – some of this will go to reduce leverage, but the rest of it is going to be sent into unitholder distributions assuming the capital markets will allow for an easy refinancing of Teekay Offshore’s 2019 unsecured debt.

At US$3/share, Teekay Offshore was an easy speculative purchase. Even at present prices of US$7/share, they are still a very good value even though they do have large amounts of debt (still trading at 16% yield to maturity, but this will not last long).

The absolute debt of Teekay Corporation is not too burdensome in relation to their assets, and one can make an easy guess that given a bit of cash flow through their daughter entities, they will be in a much better position in a couple years to refinance than they are at present. They did manage to get another US$200 million of this 2020 debt off at a mild discount in mid-November 2015, which was crucial to bridging some cash requirements in 2016 and 2017. The US$593 million face value of unsecured debt maturing January 2020 is the majority of the corporation’s debt (noting the last US$200 million sold is not fungible with the present $393 million until a bureaucratic process to exchange them with original notes) – I’d expect sometime in 2017 to 2018 this debt will be trading above par value.

The debt can be redeemed anytime at the price of the sum of the present values of the remaining scheduled payments of principal and interest, discounted to the redemption date on a semi-annual basis, at the treasury yield plus 50 basis points, plus accrued and unpaid interest to the redemption date.

This is a very complex entity to analyze as there is a parent and three daughter units to go through (and realizing that Teekay Corporation’s consolidated statements are useless to read without dissecting the daughter entities – this took a lot of time to perform properly). I believe I’ve cherry-picked the best of it and have found a happy place to park some US currency. I still think it is trading at a very good value if you care to tag along.

Bombardier bond yield curve

Bombardier’s bond yield curve has gone much more favourable over the past couple months. Their March 2018 bond issue (the nearest maturity) is trading at par (coupon is 7.5%), while going out to January 2023 the yield to maturity is trading just north of 10%.

(Update on April 18, 2016: After rumours of Delta Airlines close to purchasing C-Series jets and the rejection of the Canadian government’s bailout offer, the yield curve has compressed even further – the January 2023 yield to maturity is now at a bid of 9.5% – the rejection of the bailout offer has to be a positive signal for the company, i.e. they have the financial wherewithal to go on their own without further equity injections).

So while the company isn’t completely out of the woods yet, the market is giving them an opportunity to refinance debt if they choose to do so – However, it is unlikely a bond offering will be made until 2017.

On the preferred share component of their capital structure, their BBD.PR.B series (floating rate) is trading a shade under 10% eligible dividend yield, while the BBD.PR.C series is at 12.7% – somewhat reflecting an increased relative risk of dividend suspension, coupled with a conversion risk (as the company has the right to redeem for equity at the greater of $2/share or 95% of VWAP).

Also muddling the market news is the proposed federal government investment in Bombardier which would likely cement its ability to maintain its credit rating and dividend-paying ability of its preferred shares.

I continue to remain long on the preferred shares.

Q1-2016 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2016, the three months ended March 31, 2016 is approximately +12.3%.

Portfolio Percentages

At March 31, 2016:

44% common equities
19% preferred share equities
19% corporate debt
1% options (net of long and short positions)
18% cash

Figures do not add to 100% due to rounding.

USD exposure: 26%

Portfolio is valued in CAD;
Equities are valued at closing price;
Equity options valued at closing bid;
Corporate debt valued at last trade price.

Portfolio commentary and outlook

This was one of the most active quarters I can recall in quite some time. I deployed about half of the remaining cash into a huge smattering of issues – my research queue was bombarded with so much volume that I had a very difficult time keeping track and current (especially with the avalanche of annual reports coming due at this time of the year).

Currently, the portfolio is at an all-time record for the sheer number of issuers I have in my portfolio. I hold 6 separate equity positions, 4 preferred share issuers, and 9 corporate debt issuers. While I am generally not a fan of diversification for the sake of diversification, other than the concentration of Genworth MI in the portfolio (which is at double-digits), the other issuers are at single-digit concentrations (some higher than others). There are some positions that I took that I wish were double-digits, however!

The portfolio is also quite “yieldly” – 3 of the equity positions give out income, while obviously the preferred share positions do as well – at a double-digit level at cost. While double-digit yields for preferred shares imply the market valuing the underlying entity as a significant credit risk, there are peculiar situations that make me rate the actual risk to be much less. For example, one entity giving out a double-digit yield has a debt-to-tangible equity ratio of less than 10%, while earning positive cash flow over the past 12 months in a low point in its industry cycle. Fascinating indeed! There are gems like this scattered about the market and it makes me really wonder what is going on. Markets normally should be more efficient than this.

My theory is that the advent of ETF investing and Robo-advisors has shifted a significant amount of capital toward large-cap and major index products. Likewise in the fixed income market, such ETFs and Robo-investments have gravitated most “default” capital toward A to AAA-type credits and in the preferred share space, P-1 and P-2 credits. In addition, institutional investors (pension funds, insurance companies and the like) receive far more regulatory capital credit for sticking to these credit profile ranges and thus the majority of capital go towards these particular products and not the lesser-rated securities – although those lesser-rated securities are just as credit-worthy and thus the risk/reward ratio for them is that much better – as long as you can do your homework properly.

Some other portfolio highlights include loading up on Genworth MI (TSX: MIC) between CAD$22-25 in January as the markets took their common equity down to panic levels, and also picked up shares of parent Genworth Financial (NYSE: GNW) after their not-so-stellar earnings report.

As long-time readers of this site know, I believe Genworth MI at those prices were deeply under-valued compared to a floor price of what should be around a 10% discount to book value, or about CAD$33-34/share. Of course, fair value should be north of this price and I will not be disposing of any shares until the entity does reach a level that I consider to be over a fair value – this will likely happen if the markets decide that they wish to grant their confidence in the stability of the overall Canadian real estate market. Right now what gets the press are the million dollar “crack-houses” that get sold in Vancouver for land value (usually from foreign buyers), but the reality of the situation is that when one looks away from the extreme factors (including the depreciation going on in oil-and-gas exposed geographies), Genworth MI is very healthy and profitable.

I finally completed my analysis of Genworth Financial and believe there is a real possibility they will appreciate north of US$10/share in the upcoming years. They do have exposure issues concerning their long-term care insurance contracts they have been writing, but this risk is quite well known and has been long baked into the common share price, culminating in their Q4-2015 report where they took yet another charge once their actuaries determined insufficient reserving. It takes a considerable amount of mental concentration to strip away the various elements of their consolidated financial statements and perform an entity-by-entity analysis and come to some probabilistic estimate that they will be able to face their major challenge – how to roll over their 2018, 2020 and 2021 debt maturities in an “elegant” manner. They are getting on the right track by repurchasing debt at a discount and it doesn’t require Warren Buffett-type skills to realize that buying back your own debt at 15% yield to maturity is the best financial decision one can make.

The corporate debt portfolio has a few interesting components. There are some convertible debt offerings that are trading relatively close to their conversion rates which give a reasonably good risk-reward ratio. For companies that are not going to become “broken convertibles”, these issues represent a free option on equity upside and priced at a modest premium. For instance, if a convertible debt issue is trading at par with a conversion rate of $10/share, a medium-grade credit in a cash-flow positive entity, with a 7% coupon and 5 year maturity; if the common shares are trading at $9.70, if you see the convertible debt trading at par, there is a significant amount of optionality that remains in the debt issue that is not represented in the debt market value. It would make sense in such instances to buy the debt rather than the equity because your downside is much more limited in exchange for the 3% price below strike value.

A few other highlights include my “favourite” capital management firm, Pinetree Capital (TSX: PNP.DB), where their first-line secured senior debentures edge closer to their May 31, 2016 maturity date. After curing their debt covenant default with a very aggressive liquidation and debt redemption, they are about to close the chapter on this very sad saga and ask themselves what they can possibly do to siphon the remaining morsels of cash out of the corporation. Unfortunately because their last debt redemption involved an equity component I own a few shares in this calamity and I patiently await their execution on hopefully arranging a sale of their capital loss tax assets, amounting to about half a billion squandered to date. I liquidated the round-lot amounts of my debentures at 101 cents on the dollar and the rest will presumably mature in the second quarter.

I do not expect the performance achieved in the first quarter to be sustainable over the next three quarters, but I do anticipate modest portfolio growth at relatively low levels of risk. For instance, all the equity securities I have purchased were under book value which provides a margin of safety. The preferred shares I have purchased are in corporations that are priced like there will be severe risk of defaults, but when reading the financial statements there are no obvious worries (and in industries that will not be going away – it is not like I’m investing in newspaper corporations!).

At quarter’s end, I do not see as much opportunity as I was seeing at the end of January (up until the middle of February), but I am still retaining plenty of cash to seize opportunities as they come around. While I believe this current market rally does have enough legs to last a couple more months, as we end up in the antics of the presidential election cycle, the world is going to go topsy-turvy once again, and fiscal prudence will be the order of the day. The good news is that I’m being paid to wait.

The gain in the Canadian dollar over the quarter also suppressed the reported performance figure a couple percent. My internal policy on currency is fairly simple – keep a relative balance between USD and CAD and buy more CAD when the US dollar is strong and sell CAD when the US dollar is weak. In general, I think the CAD is at a relatively high point (at 77 cents on the dollar), but I do not have strong opinions about it otherwise.

The TSX was up 3.7% over the same time period, while the S&P 500 was up 0.8%. While I am outperforming the major indicies (and have been doing so for over the past 10 years), I do not believe there is a valid benchmark that my portfolio can be compared to – it goes for the best risk/reward I can identify. Sometimes this will mean I can make an “easy” 7%, while sometimes it will reach for the stars and go for 50% in a year. Right now I think there’s a good 20-30% of upside remaining.

I am getting concerned, however, that the markets generally tend to crash during the presidential election cycles. So this optimism on my own portfolio is not translated to the broad market in general – I think there will be a lot of see-saw type action, as reflected by the following chart:


In markets that go sideways, fixed income securities are your best friend. Fixed income securities will dip when the broad markets go down (momentum funds and margin liquidations will go hand-in-hand in these situations), but not as badly as the equities themselves.

The biggest trade not made and the power of managing your own psychology

Still kicking myself for not buying Data Group debentures (TSX: DBI.DB.A) post-recapitalization announcement (late 2015). I really have to congratulate the people getting in at 35 cents on the dollar or below here. Normally I have no psychological hurdles about just forgetting about bad trades or good trades I should have made but never executed on, but this one was my biggest all-time “the baseball is right in the middle of the plate on a slow pitch and never even took a swing at it for even a single” trades. It would have been a small position – around 2%, but still, when measured in absolute dollars I always like to think of how much (good) sushi it can buy.

C’est la vie.

That said, this quarterly performance result made me feel a little better for myself, and the fact that I have done so with a very conservatively positioned portfolio and high cash quotient is somewhat reassuring.

General advice to myself that has kept me out of trouble

Avoid all stocks that make headlines. Good examples include Valeant (TSX: VRX), SunEdison and daughters (Nasdaq: SUNE, TERP, GLBL), etc. While there might be days these stocks gain 20% on volatility, it is nearly impossible to time, there are too many eyeballs looking at these issuers and I have zero competitive edge actually trying to analyze the actual business prospects of these firms. While they may be entertaining to look at from a media standpoint, from an investment standpoint they all represent pits of money where there is no return.

Long-time readers of this site will then wonder what the heck I am doing investing in Bombardier preferred shares, but I believe I have an edge over the market in this instance with my technical and political knowledge of their specific situation.

Long-Term Performance

Interestingly, my 10.25 year performance, compounded annually, works out to +15.00%, rounded to two decimal places. For comparison, Berkshire Hathway’s share price performance over the past 10.25 years was +9.1%. This is not a fair comparison, as managing a two hundred billion dollar portfolio has much more complexity than my (by comparison) flea-sized portfolio. According to efficient market theory, I should not be able to outperform the markets. Yet, I continue to do so. Am I just getting lucky?

Portfolio - 2016-Q1 - Historical Performance

Performance and TSX Composite is measured in CAD$; S&P 500 is measured in US$. Total returns indices are with dividends reinvested at time of receipt.
YearDivestor PortfolioS&P 500 (Price Return)S&P 500
(Total Return)
TSX Comp. (Price Return)TSX Comp.
(Total Return)
10.25 Years (CAGR):+15.00%+5.01%+7.19%+1.77%+4.71%

Pengrowth Energy Debentures

This will be a short one since my research is done and my trades have long since executed. I will not get into the sticky details of the analysis.

Pengrowth Energy has CAD$137 million outstanding of unsecured convertible debentures (TSX: PGF.DB.B), maturing March 31, 2017. The coupon is 6.25%, and the conversion rate is CAD$11.51/share (which is unlikely to be achieved unless if oil goes to $200/barrel in short order).

Because of what has been going on in the oil and gas market, the debt has been trading at distressed levels. It bottomed out in January at around 47 cents on the dollar (this was a one day spike on a liquidation sale), but generally hovered around the 60-65 level. It is trading at 88 cents today.

It is much, much more likely than not it will mature at par.

There are a few reasons for this.

The debentures are the first slice of debt to mature. Pengrowth’s capitalization is through a series of debt issues with staggered maturities.

Pengrowth has a credit facility which expires well past the maturity date and is mostly under-utilized and can easily handle the principal payment of the debentures.

Pengrowth’s cost structure is also not terrible in relation to the operations of other oil firms.

Today, Seymour Schulich publicly filed his ownership of 80 million shares of Pengrowth, which equates to just under 15% of the company. Seymour Schulich owned 4% of Canadian Oil Sands before it got taken over by Suncor, so I’m guessing he was looking for another place to store his money in the meantime. I think he picked well. Schulich also owns 42 million shares (28%) of Birchcliff Energy (TSX: BIR), so with these two holdings, he owns a very healthy stake in both oil and gas.

This last piece of information seals up the fact that barring another disaster in the commodity price for oil that the debentures will mature at par. The only question at this point is whether they’ll redeem for cash or shares (95% of VWAP), but I am guessing it will be cash.

Even at 88 cents on the dollar, an investor would be looking at a 13.6% capital gain and a 6.25% interest payment for a 1 year investment. This is under the assumption there is not an earlier redemption by the company.

I was in earlier this year at a lower cost. I will not be selling and will let this one redeem at maturity.

Pinetree Capital will undergo a change of control

A company that I used to write about in the past, Pinetree Capital (TSX: PNP), will finally be undergoing a change of control.

I own a small portion of their senior secured debentures (TSX: PNP.DB). This holding was much larger earlier in 2015, but they were mostly liquidated through redemptions throughout 2015. By virtue of the last redemption (which was partially paid out in equity) I also own a small amount of equity in Pinetree Capital that I have not bothered to selling yet as they were trading below my opinion of fair value.

I anticipated that the final liquidation of the public entity would be in the form of a constructive sale of its sizable ($500 million+) capital losses. Instead, it comes in the form of a rights offering. I’m not sure what the formal terminology of this is, but I would call it a passive takeover.

Pinetree will issue rights that are exercisable at 2.5 cents per share (which is about a penny, or nearly 1/3rd, below their existing market price). If no more than 40% of these rights are exercised, then a numbered corporation entity controlled by Peter Tolnai will exercise the remaining unexercised rights and take control of approximately 30-49.9% of the company. Tolnai also receives $250,000 for his efforts (probably paying for a lot of legal and advisory fees to structure the rights offering).

Considering only 22 million shares (of approximately-then 200 million shares outstanding) were voted in their last annual general meeting, it would be a reasonable bet that investor appetite to purchase further shares in Pinetree will be most certainly less than 40% of the existing shareholders. A 30% stake in the company is akin to effective control. I have some fairly good guesses why Tolnai would not want more than 50% ownership of the company.

The rights will be traded on the TSX, but my analysis would determine the price would trade at bid/ask $0.005/$0.01 assuming the common shares are trading at bid/ask $0.03/$0.035. As a result, the rights would not be easy to liquidate after transaction charges and would probably remain relatively illiquid.

Peter Tolnai, judging by his website, feels like somebody I could relate to personally. My guess is that he is taking a strong minority stake in the company for the purposes of obtaining a functional, inexpensive, and public entity to raise capital and utilizing the rich reserves of capital losses to grow capital tax-free. I would deeply suspect he has a team in mind and will be raising capital after the April 22, 2016 special meeting that will authorize a (much needed) 100:1 reverse split.

The net proceeds of the rights offering is to pay off the senior secured debentures, which mature on May 31, 2016. The amount outstanding on the debentures is not huge – $6.7 million principal plus six months’ interest (another $335,000). However, Pinetree has disclosed in its filings that if it is unable to raise money with these rights, they would have to liquidate its remaining privately held investments, implying it does not have anything liquid anymore.

Considering Pinetree Capital has not released any financial information since the end of their September 30, 2015 quarter, it remains to be seen what their current balance sheet situation looks like on the asset column. I’m guessing they sold off all of their liquid publicly traded securities in 2015 (the largest of which was PTK Technologies). Pinetree must release their audited financial statements for the year ended December 31, 2015 by the end of March.

Shareholders as of March 23, 2016 will receive the rights to buy at 2.5 cents per share (which means March 18, 2016 is the last day to purchase common shares if you wish to receive rights), but somehow I don’t think the market will be bidding up Pinetree common shares.

This leaves the last question of the valuation of the final entity, assuming the rights are exercised in full. With the senior secured debentures paid off, there is likely a non-zero value in the company, but a better snapshot can be obtained after the release of the year-end 2015 statements. Another question will be how Peter Tolnai’s team will plan on making capital gains and utilizing the huge tax assets left in Pinetree, but considering he will likely have a 30-49.9% stake in the company, his incentives are well geared towards the passive shareholder base.

Utilizing Pinetree’s capital losses is actually a problem that I would like to help him solve, to quote a line from his “Giving Back” section on his biography, if I was so privileged!

Re-examination of Yellow Media

I’ve written about Yellow Media (TSX: Y) extensively in the past on this site before their recapitalization.

I’ve been generally surprised at their financial performance – from 2014 to 2015, revenues dropped only 5% and while EBITDA margins have compressed (to around 31% from 36% before special items), the negative trajectory is flattening out rather than an accelerated drop. Notably they’ve been generating a ton of cash relative to their market capitalization – $73 million in 2014 and $122 million in 2015.

Balance sheet-wise, they are still leveraged. After their recapitalization, their senior secured debt holders receive a mandatory redemption payment of 75% of free cash flow. In 2015 they repaid about $100 million of debt and since the recapitalization (December 2012) the total has been $393 million, or nearly half the balance outstanding. It is probable that they will be able to redeem another $100 million in 2016 and by that point it should be evident they will be home free (in addition to paying less onerous financing charges).

They reserve the right to redeem more debt prior to May 31, 2017 for 105%, and afterwards at par value. Thus, it would make sense that the company would be aiming for June 1st for a refinancing of existing debt and a removal of the pesky covenants that have been restricting management’s ability to perform other functions with their capital.

The only other debt outstanding are unsecured debentures (TSX: YPG.DB) of which $107 million remain outstanding. These debentures have a coupon of 8% and mature on November 30, 2022 – quite a long-dated debenture. Only after the senior secured debentures are matured, these debentures can be called by the company at 110% of par anytime, or 100% after May 2021. The company can also choose to defer cash interest payments and accrue a 12% payment-in-kind provision but so far they have not exercised this route.

Another feature of these debentures is that they can be converted to Yellow common shares at $19.04 – which is barely above the existing market price of $18.95 on Friday’s close.

This creates an interesting valuation puzzle. Investors have functionally sold a call at 110% of par to the company contingent on the redemption of the senior secured debt, while they have an embedded call linked to the common share price.

In terms of business valuation, if Yellow Media’s revenue/EBITDA margin trajectory remains roughly what management projects (which amazingly to date has been generally the outcome), Yellow Media should be earning somewhere around $70 million in net income. This would work out to $2.50 per basic share outstanding (not accounting for dilution if the debentures convert). If there is a modest growth valuation assigned to the company, one can make a case that Yellow should be trading around $30/share and not the $19/share it is trading at presently.

This would place a valuation of about 150-160 cents on the dollar for the debentures, with relatively little downside from current market prices (the bid of 109 would go down to somewhere around par if the underlying business eroded faster than the current trajectory).

This also does not account for the time value of the at-the-money call option within the debentures – currently their warrants with a strike of $28.16 (nearly 50% above current market value) and an expiry of December 2022 trades at $4.13, so there is clearly time value in the call option.

The warrants are unattractive because break-even would be a common share price of $36/share (i.e. if you bought warrants at $4.13 vs. common shares at $18.96, you would do equally well with an investment if the common went up to $36/share at expiration – note your warrants would do significantly better if $36/share was reached prior to expiry).

While I am not interested in the common shares or warrants, I did buy a small amount of debentures near par in January with the expectation of holding onto them until they are likely redeemed (or if the common shares trade above $20.94, converted). They are a low risk, medium reward type investment. I will caution anybody wanting to trade them that you should be prepared for a very slow market and part of the reason why I have such a small holding is because of the relative market illiquidity.