Marijuana stocks – if there was any question of over-valuation

This post applies to the recent December 5, 2017 press release by the British Columbia government regarding how they plan on implementing marijuana regulations in the province.

Saving you from reading the actual release, they plan on having a sole wholesaler (the BC Liquor Distribution branch) and a private/public retail distribution mechanism.

This is very similar to how liquor in other major provinces are distributed – the government gets to keep the lion’s share of the profit on the wholesale side.

In British Columbia, retailers can purchase product from the government monopoly wholesaler at a 16% profit margin for licensed retail stores. These stores will have to then sell enough volume in order to pay for the usual business expenses (leasing a physical location, maintaining inventory, staffing, etc.).

Using the liquor analogy, profits from the retail end of things will be minimal. The best example is Liquor Stores NA (TSX: LIQ) which, despite booking 25% gross margins on their product, when things are good, earn a 3% operating profit margin (not before financing costs, but this is after depreciation expenses).

People following this company will shout out that they are undergoing a significant restructuring, but the central theme still sticks – it is a very low margin industry when your only supplier is government-controlled and has every incentive to maximizing its own profit and not yours.

This is a miserable business climate to be in.

Another, much smaller, example is Rocky Mountain Liquor (TSX: RUM). They operate retail entirely out of Alberta. Cherry-picking their best results in the last year, they are earning a 2% operating profit margin (and this is BEFORE financing and depreciation expenses).

Is marijuana going to be any different than liquor?

I would float the claim that retail marijuana profitability will be even worse than liquor because people can easily grow their own product sufficient for their own consumption. Federal legislation actively encourages people to grow their own marijuana plants at home (4 plants that you can now grow larger than the original 100cm proposed in the initial draft of Bill C-45).

This leaves the question of wholesale – there will need to be suppliers of this. I will also make the claim this will be a race to the bottom, with the exception that the “grow it at home” market will erode profits to the point that wholesale will nowhere near justify the 3.6 billion market capitalization seen from Canopy Growth (TSX: WEED) today – even assuming they captured the entire Canadian marijuana market.

The hype is marijuana producers will be able to achieve tobacco company margins – Rothmans was the last publicly traded Canadian tobacco company and they achieved roughly 50% operating margins (before financing and depreciation). It won’t be happening this way again – this margin will be siphoned by the government from the very beginning.

Get ready for the biggest short squeezes of all times – Bitcoin

It seems pretty obvious to me that talking about Bitcoin as the “biggest short of all times” is only going to end up as one way – the biggest short squeeze ever known in the history of mankind before finally busting down on a slow journey to nearly zero.

I think the last time this happened was when the Hunt brothers were partially successful in cornering the silver futures market, before they lost control and it all collapsed underneath.

Another great example was when Porsche nailed short sellers of Volkswagen stock in 2008 by accumulating a hidden option to acquire 75% of the company, with the German state owning 20% – leaving precious little for short sellers to cover with.

The real issue here is marginability of Bitcoin futures – it doesn’t even matter if margin rates are 35% or 100%, if Bitcoins trade from $10k to $100k in a three-day period, we will start to see FXCM-type action in the brokerage sector and derivative clearing, just as the chairman of Interactive Brokers promised.

Once the short interest in bitcoin futures starts to rise, it is like adding gasoline to a six tonne pile of gunpowder and expecting everything to be all right while lighting up a cigarette next to it. Good luck.

This is starting to make gold look increasingly like a good bet.

Just for full disclosure, I’ve known about Bitcoin since it was under a dollar a coin, and clearly I was taken aback at how it has morphed into present day. I’ve been outright incorrect regarding pricing predictions.

Further disclosure: Have not owned, nor do I intend to take any positions on bitcoins, which is the closest thing one can get to legalized gambling.

Little activity to report

This quarter is looking to make records for low activity on my part. I’ve been attempting to scan the markets for various opportunities but have been coming up with blanks.

In general, most of the debt markets out there are trading out of proportion for risk. Blow-ups on unsecured debt like Toys R Us continue to be a reminder that something can go from 95 cents to 30 in short order.

The fossil fuel industry (specifically natural gas production) appear to have headwinds, and despite rumblings of a recovery in the crude oil market, I still do not see anything on the equity side that appears to warrant action at this point.

Retail has also been killed, but in many cases there is a lot of substance to the story – there is a generational shift occurring for physical shopping, similar to the digitization of newspaper media.

Indeed, it appears that two industries have been dominating the mind-share for investment capital: Marijuana and Blockchain technologies, neither of which I have any interest. I note with amusement that Village Farms (TSX: VFF) appears to be attracting disproportionate interest due to its announcement that it is preparing to grow marijuana in its greenhouses (presumably in British Columbia and not Texas!). I have no idea how far up the market can take these stocks (similar to Bitcoin itself), but it can always be father than one can believe is possible, let alone rational.

The good news is that when a few sectors dominate the allocation of capital, it usually means that other sectors do not receive the same attention and these can be scoured for opportunities.

Despite my antagonistic view on the general marketplace, most of my cash is deployed in cash-parking vessels and are earning incremental yields while I wait for higher risk/reward opportunities. Although I do not think a market crash is imminent, if one did occur, I would not mind.

Genworth MI’s slow ascent

Genworth MI (TSX: MIC) reports their third quarter earnings on Thursday.

The stock has been on a mild uptrend as of late:

I suspect in absence of anything material in the Canadian real estate market, that the upcoming quarter will be financially positive and the market has already anticipated this.

Genworth MI is also likely to announce an increase in their quarterly dividend. They also executed on a modest share buyback in the previous month.

Probably the biggest amount of uncertainty would come from the parent company, Genworth Financial (NYSE: GNW) where it is not apparent whether their merger will receive sufficient authorization from the federal government authorities to proceed or not. Because they have an upcoming US$600 million debt maturity in May 2018, things are getting a bit tight financially – while their holding company does have around $800 million to work with, an analogy after $600 million of that goes to pay the debt would be like running the automobile with no bars of gasoline left on the tank gauge.

Their 10-Q states, “In the absence of the China Oceanwide transaction or in the event we are unable to refinance our debt maturities, we expect we would be required to pursue asset sales, including potential sales of our mortgage insurance businesses in Canada and Australia and/or a partial sale of our U.S. mortgage insurance business to service our holding company debt.”

Will Genworth MI be sold? It would be an easy US$1.6 billion for them or more depending on how much of a premium they receive…

ROOTS IPO – Completely over-valued

Roots (TSX: ROOT) went public today. Look at the chart!

The only shock I have at today’s market reaction (it is trading down $2 from its initial price of $12/share) is how the institutions managed to find enough buyers at $12 to actually complete the sale. That was one heck of a sales job considering that anybody that is able to read a financial statement (do any financial institution managers ever read these prospectuses anymore??) would steer clear of this one. It isn’t even close in my estimation.

Conclusion: Another money-losing, negative book-value entity that has a huge uphill climb if it is to ever return any dividends to shareholders. I even love the $20 million distribution on May 2017 that Searchlight took out of the company before going public even though they were pushing the top of their credit limit (which was expanded on April 19, 2017). Will Roots go into creditor protection in a couple years?

There are some IPOs that make me think and wonder whether they’re worth purchasing (at least they’re worth the research). This one is an easy, easy pass.

Interactive Brokers CEO Thomas Peterffy on Bitcoin

Just reading the Interactive Brokers Q3-2017 conference call, we have the following amusing dialog between an analyst and CEO Thomas Peterffy:

=============

Mac Sykes
Understood. And when I think of IBG, I think of technology innovation, a broad suite of global product vehicles and as you mentioned, sophisticated traders. And love it or hate it at this point, Bitcoin’s market cap is now about 1/3 of JPMorgan’s. So 2 questions on this. Have you considered accessing this marketplace? And number two, have you heard client feedback asking for this kind of access?

Thomas Peterffy
The answer is yes to both, and the result is that we’re not going to do it.

Mac Sykes
Got it. What would make you just change your mind?

Thomas Peterffy
If the United States of America said, you know, besides dollars, we also have Bitcoins, and you can pay your taxes in Bitcoins, we would be the first one to go and do it.

=============

Ouch. Interactive Brokers is a brilliant, brilliantly run company, but the public entity is a company that only owns 17.4% of the actual operation. It is primarily for this reason and valuation that I am not an investor, but it is up nearly 50% over the past half year and strategically I think they are hitting every correct button in their business execution.

Morneau Shepell Inc. Research

After the news that the Minister of Finance, Bill Morneau, will be selling his remaining stake in Morneau Shepell (terms and conditions to presumably not disclosed), it was time to look at the company. Whenever you hear of anybody forced to liquidate a stake in a company (especially through a margin call) it is always time to look to see if the underlying company can be bought for cheap. When something like this becomes too public (which I believe this news would qualify as), the opportunity to take advantage is diminished, but it is still worth examining.

There are two issues trading on the TSX, the equity (TSX: MSI) and a $86 million convertible debenture (TSX: MSI.DB.A) that matures on June 30, 2021; coupon 4.75%, conversion price $25.10.

I’ve examined the June 30, 2017 financial statements. The corporation has about 55.7 million shares outstanding, diluted.

Valuation

On the balance sheet, the company is primarily financed with debt. Book value is $366 million, but $543 million of this is in goodwill and intangibles, which leaves a negative $177 million equity balance. This, in addition to working capital, needs to be paid for with debt financing. They have a $300 million available credit facility, and are currently utilizing $186 million. They also have the aforementioned $86 million in 4.75% convertible debentures outstanding. This financing is very cheap – the bulk of the credit facility is at Banker’s Acceptance rates plus 1.45%. Overall, the company is financed with very inexpensive debt financing. If at some point in the future financing costs were to increase, this would put considerable stress on the balance sheet and would be disruptive to shareholders if it occurred.

Income-wise, the company is stable and profitable. For the first half-year, they made $36.1 million before interest and taxes, and net was a shade above $20 million. Cash-wise, they are performing slightly worse than their income statement (operating cash flow was $15 million for the first half). Their dividend payout amount was $21 million for the half, and thus when accounting for capital asset acquisition and other business acquisitions, they are currently a cash negative entity unless if they can curtail their cash outflows.

The market capitalization of MSI is $1.1 billion and for an entity that has a negative tangible book value and only flowing (making some paper napkin adjustments that I will omit from this analysis) about $45 million annualized cash flow, does not make them a compelling investment at current prices. If the company’s equity traded around the $500-550 million level (about half of what it is trading for currently) I might get interested, but I do not see this as a probable scenario.

The convertible debenture is trading at 105 cents on the dollar (effective yield is 3.2% assuming maturity). Given the elevated equity valuation, the market is clearly pricing in some call option value in the debt, but given the high equity valuation I would not consider this debt for purchasing at existing valuations.

Minister of Finance Sale

Over the past month, about 50,000 shares of MSI trade daily. The Finance Minister, from an April 2, 2015 SEDAR filing (Management Information Circular) owns or controls or directs 2,247,812 shares of the corporation. This is presumably through the family trust that is speculated around with media, held in an Alberta corporation.

Where things look odd is when I look at his profile on SEDI (profile ID WMORNEA001) – He ceased to be an insider on October 26, 2015. According to SEDI filings, filed on various dates in 2015, he owned/controlled long term incentive plan shares and deferred share units, but there is no evidence on SEDI that he owned or controlled any common shares of MSI, which I find very odd and mysterious as it does not reconcile at all with the April 2, 2015 management information circular.

My big question: is the non-disclosure of the family trust an Ontario Securities Act violation? If Morneau had control over a larger number of shares than declared on his SEDI disclosure, is that not a non-disclosure that would be subject to penalties? A competent securities lawyer or somebody better versed in this section of law than I am would be able to answer this.

(Addendum, October 26, 2017: Turns out I totally missed the entry for his numbered Alberta corporation’s holdings of 2 million shares – so this was disclosed – back in 2011)

Also I’m cynically concluding that given the over-valuation status of MSI, the Finance Minister is also conveniently choosing this moment to unload shares.

Bombardier ran out of money

There is no way to explain Bombardier selling out a 50.01% stake of its C-series jet (leaving it with a minority 31% stake, with the Government of Quebec with a 19% interest) to Airbus for zero other than the simple fact that they ran out of money. They couldn’t keep things going for a few more years while all of the trade dispute issues played out.

With airbus fully incentivized to starting marketing the C-Series (and acquiring most of any industrial secrets contained within the aircraft design), they will be better positioned than Bombardier was with respect to the upcoming Boeing trade dispute (which will be a multi-year bloody battle, especially since Boeing has the full support of the US Government). One question internally for Airbus is how they will reconcile selling Airbus 319’s instead of CS300’s with this arrangement. Or are they just doing this to shut down the aircraft entirely?

The key paragraph is:

At closing, there will be no cash contribution by any of the partners, nor will CSALP assume any financial debt. It also contemplates that Bombardier will continue with its current funding plan of CSALP and will fund, if required, the cash shortfalls of CSALP during the first year following the closing up to a maximum amount of US$350 million, and during the second and third years following the closing up to a maximum aggregate amount of US$350 million over both years, in consideration for non-voting participating shares of CSALP with cumulative annual dividends of 2%, with any excess shortfall during such periods to be shared proportionately amongst Class A shareholders.

So Bombardier’s downside is US$700 million over the next couple years.

Long term, assuming this isn’t an agreement by Airbus to effectively shut down the C-series program, this should bode well for the C-Series program, which should remain in Canada and will have a more powerful marketing partner, but this is a negative for any upside to Bombardier – the promise of a wildly profitable commercial jet program will have now shrunk down to a 31% stake.

If I was going to use an analogy here, it is “Would you like 31% of something, or 100% of nothing?”. Bombardier seems to have taken the first option.

Bombardier has plenty of other cash-positive business units (Transportation and smaller-scale aircraft) that will be bringing in cash flows, but most of the upside in the business (via the promise of significant C-Series jet revenues) is gone.

I continue to hold a much-diminished stake of BBD.PR.C and BBD.PR.D shares, of which I am tepid on valuation and still do not see any imminent (I added in this word a couple hours after making this post!) dividend risk despite this deal.

Yellow Media – Senior Secured notes debt re-financing

Yellow Media (TSX: Y) managed to refinance its 9.25% senior secured notes due November 30, 2018 to November 1, 2022. According to the press release, the new notes are priced at 98 cents on the dollar and will give out a 10% coupon. This works out to roughly a 10.6% effective yield (assuming payout at maturity of par value).

The original senior secured notes had a payment provision where the company had give out a large percentage of its free cash flow to redeem the notes at par. It is not known whether that covenant will be in place for the new notes issuance.

My question is – why are the unsecured debentures (TSX: YPG.DB) (due November 30, 2022 and about $107 million principal value) trading at a value that is comparable to the 10.6% yield of the newly issued senior secured notes? The conversion option at $19.07/share is over double out-of-the-money and these holders don’t have security. It would seem to me that the unsecured debentures should be trading lower.