Genworth MI – 4th quarter 2015 report

Genworth MI (TSX: MIC) reported their 4th quarter and year-end earnings yesterday.

I have been covering Genworth MI since 2012. While I liquidated a significant portion of the company in 2014, as a result of the price depreciation exhibited over the past three months I have taken the liberty to once again make MIC the largest position in my portfolio (at prices from 22 to 25 a share) as I believe it is trading well below my estimate of their fair value. Companies trading at a discount of over 1/3rd of their tangible book value and at a P/E of 6 either are fraudulent (which is clearly not the case with Genworth MI) or have external sources of perceived stress causing such an intense discount.

Financial Statement Review

I will pick off some salient details of their report.

1. From year-to-year the balance sheet saw an increase of about CAD$450 million of real assets (cash, bonds, preferred shares, common stock) relative to the end of 2014. Roughly half of this was through an increase in deferred premiums (money collected for mortgage insurance that is held on the liability column of the balance sheet until it is recognized as actual revenue in accordance to a model for historical loss experience) and a good chunk through retained earnings.

2. Premiums written were up to $809 million for the year, compared to $640 million the year before (a 26% growth). You can thank the CMHC for this. Alberta went down from 26% in 2014 to 22% in 2015.

3. They continued to add to their preferred share portfolio; they sold their common shares and moved to preferred shares, which is still sitting on an unrealized loss position of $33 million on a $281 million cost base; this is better than Q3-2015 which was $42 million unrealized loss and $236 million, respectively. Given the existing valuation state of the Canadian preferred share market, shifting to preferred shares is a value-added decision especially when considering the positive tax consequences of inter-corporate dividend income for insurance companies. 92% of their portfolio is rated “P2” and the remainder is “P3”.

4. The company repurchased $50 million of shares and outstanding shares is down from 93.1 million at the end of 2014 to 91.8 million on December 2015.

5. The company’s debt maturing in 4.5 years has a yield to maturity of roughly 3.5% (traded at 109 cents on the dollar at year end). Their maturity at 8.25 years out was trading at a very slight premium and is YTM 4.2%. Back on November 6, the company was exploring a debenture offering. Their cost of raising debt capital seems to be relatively low, so it is curious why they never proceeded with it.

6. Delinquencies have not materially picked up in Q4-2015 (rate still is 0.1%).

7. Minimum capital test ratio goes from 227% to 233%. Management has pledged repeatedly that their target is “modestly above 220%” in terms of capital management. It is getting to the point where they will likely execute on another share buyback, and considering the huge discount to book value, they should consider a dutch auction at around CAD$25 to get those shares very cheaply off the books instead of dealing with a thin marketplace (recognizing that Genworth Financial owns 57% of the shares outstanding). As they have 13% in excess of 220%, this translates into about $203 million in excess capital.

If they managed to buy back 8 million shares for $200 million, they’d be able to increase book value by over a dollar a share! At existing valuations it would make complete sense for them to go private, but since Genworth Financial is facing huge financial challenges, they’re not the entity that is going to do it. This is a contributor to the depressed share price of Genworth MI (the market knows that Genworth Financial is facing pressure to sell the entire asset for a pittance).

8. The company expects lower amounts of mortgage originations in 2016. This will negatively impact premiums written in 2016. They did take 4% market share from CMHC in 2015, however, which may offset the decrease in originations.

9. Loss ratio is expected to be between 25-40%, which is more than the 20-30% guidance given for the 2015 year. Loss ratio guidance has always typically been conservative in nature. Considering the combined ratio for 2015 has been around 40%, an extra 10% on the loss side would put it at 50% and thus not anywhere close to endangering the profitability of the company.

Extra thoughts concerning valuation

Stated book value per diluted share is $36.82 – this is 35% less than the current market value of $23.91/share. If the company continues to book premiums written at $800 million in 2016 and maintain a combined ratio of 50% (30% loss, 20% expense), this would still be quite an undervalued entity.

I see two issues of market price stress:

1. The perception that the Canadian housing market will collapse and cause a huge wave of defaults which would bring mortgage insurers down like what happened in the USA in 2008;

2. Parent Genworth Financial’s issues spilling over onto Genworth MI – Genworth Financial needs money out of their subsidiaries and the trickle-down effect of dividends will not cut it for them. They can consider capital transactions (share buybacks) and keep their proportionate stake which enables them to bleed money out of the company at an accelerated pace, but this would still not be adequate for their situation. The market is likely taking the MIC subsidiary down in value on the implied assumption of a fire-sale of the 57% stake in the company. Of course, Genworth Financial would have to be completely desperate to do it at a 35% discount to book value (not to mention a P/E of 6), but the question here would be: Would they be willing to sell the whole thing at book?

Dundee Corporation – DC.PR.C – Series 4 Preferred Shares – Amended Exchange Offer

You can read my previous analysis piece on the original exchange offer here.

Dundee Corporation has announced a revision to the exchange offer. This offer would have never been made if there were sufficient votes to accept the original exchange offer (2/3rds of votes required).

The management information circular has not been posted yet, but James Hymas beat me to the punch to providing some of his always excellent analysis on anything relating to preferred shares.

My own quick summary is: the deal stinks less compared to the original offer, but it still stinks.

The revised terms of the amended offer compared to the original exchange offer include:

– The removal of the $0.223/share consent payment for shareholders voting yes to the proposal before a specified date.
– The ability to redeem 15% of the issue on June 30, 2016 and a further 17% of the then-issue (i.e. another 14.45% of original issue size) on June 30, 2018January 31, 2018;
– An increase of the dividend rate from 6% to 7.5%;
– Granting of 0.25 warrants to buy DC.A stock with a strike price of CAD$6.00 with an exercise price of June 30, 2019 (which will be listed on the TSX).

Closing Market Prices for Reference

DC.A: $5.95/share (no dividend)
DC.PR.B: $12.00/share (11.9% yield)
DC.PR.C: $14.43/share (6.2% yield)
DC.PR.D: $9.50/share (11.8% yield)

Analysis

The meeting date has been postponed to January 28, 2016, but shareholders of record on December 3, 2015 (per the original exchange offer) will have a vote on the matter. They chose to keep the original record date – a revised record date would include shareholders that were more willing to buy into the terms of a sweetened exchange offer.

By far and away the most important provision is the removal of the $0.223/share consent payment. This consent payment introduced the concept of a prisoner’s dilemma where if you believe the deal was going to pass, you would be incentivized to vote in favour of the deal despite how bad it was.

Without a prisoner’s dilemma, there is no incentive to voting yes for a marginal or mildly adverse offering (which was the only way the previous offering had any chance of passing).

This deal still stinks, but the removal of the $0.223/share carrot will remove votes in favour because (and this is my personal speculation) most of the shareholders are angling for the June 30, 2016 redemption.

So now, shareholders can vote against the proposal and face no “punishment” of having missed out on a consent payment.

Notably the consent payment for the intermediaries is still in effect – brokers will receive $0.1784/share for each vote in favour received by January 21, 2016 and $0.0892 by January 26; so if you are indeed in favour of this bad deal, it would be in your best interest to vote your shares at the actual meeting so the company doesn’t have to pay out consent payments to third parties!

The ability to redeem 15% of the shares on the original June 30, 2016 redemption date is “nice”, but not of material economic consequence. The subsequent tranche (14.45% of the original offering size) on June 30, 2018January 31, 2018 is long-dated enough that credit risk considerations come into play (for instance, the company’s credit facility would have to be renegotiated at this point and you would expect their subsidiaries would actually start making money at this point).

The increase of the dividend rate to 7.5% reflects the very weak trading performances of the other two preferred share issues (yielding nearly 12% at current prices). James Hymas has done a much better job than I could explaining the quantitative details of this component. Credit risk, especially by redemption time, becomes a huge factor in properly determining the course of action for this exchange offer. Dundee is good for a June 30, 2016 redemption through the unused portion of their credit facility. After this, who knows?

I will attempt to ballpark a valuation of the warrants. The company stated the warrants would be listed on the TSX if the exchange offer is accepted and this would give preferred shareholders a venue to liquidate for immediate cash proceeds. While the historical volatility of Dundee common shares as of the past 30 days has been around 80%, their at-the-money options currently trade at an implied volatility of 42%. Using Black-Scholes valuation (which is not the best way to value long-dated options, but is good enough for paper napkin purposes such as this post) we get an option value of $1.84/share, or about 46 cents per preferred share (as each share would receive a quarter warrant).

Using some more formal methods involves different results – if you are that bullish on Dundee’s common stock, why bother playing around with the preferred shares when you can simply buy the common shares or even the other preferred shares?

Doing some simple sensitivity analysis, if Dundee traded to $8 (25% higher) between now and the January 28, 2016 special meeting, the implied value of the warrants per preferred share would be approximately 83 cents (50 cents intrinsic value and 33 cents time value), assuming implied volatility doesn’t drop (in reality – it would slightly). 83 cents does not come close to mitigating the capital losses that have occurred between the initial offering (when shares were trading at CAD$17) and when the exchange offer was proposed. Right now preferred shareholders are sitting on a $2.60 drop in market value and this exchange offer will come nowhere close to compensating them even with the increased coupon and partial early redemption rights.

I also find this statement to be amusing:

The determination of the Board of Directors is based on various factors, including a fairness opinion prepared by GMP.

Apparently the original exchange offer was fair, but the amended one is as well! Is there any offer that wouldn’t be considered fair by GMP?

Conclusion

Preferred shareholders have an even easier decision this time around – vote against the offer. It is still terrible compared to the existing Series 4 preferred shares.

As I have disclosed in my prior post, I sold out my DC.PR.C position between $17.20-$17.44/share in late November/early December. I’m a spectator at this point.

Update January 9, 2016: The initial part of this post had the second redemption date as June 30, 2018 when it should be January 31, 2018. The above has been corrected and the 5 month difference does not materially change the above analysis.

2015 year-end report

Portfolio Performance

My very unaudited portfolio performance in the fourth quarter of 2015, the three months ended December 31, 2015 is approximately +0.4%. My year-to-date performance for the year ended December 31, 2015 is approximately +9.8%.

Portfolio Percentages

At December 31, 2015:

18% equities
24% preferred shares
16% corporate debt
42% cash

USD exposure: 33%

Portfolio is valued in CAD;
Equities and corporate debt are valued at last traded price;
USD Cash/Equity valued at closing exchange rate of 0.7228 CAD/USD.

Portfolio Commentary

This was a bit of a rollercoaster quarter for me, but a good year overall.

I substantially outperformed the S&P 500 and TSX Composite this year. Although I received a boost due to the depreciating Canadian dollar (this was not trivial – had the 86 cent Canadian dollar held during the year the portfolio would be sitting at a CAD-denominated +5% for the year instead of +10%) the portfolio choices for the most part performed as expected and I was able to take advantage of certain situations with very good precision. Bailing out of Dundee preferred shares (TSX: DC.PR.C) was near-perfect timing, and there was another situation involving a dutch auction tender which I managed to completely capitalize from (the common shares were tendered at the maximum range and subsequently cratered – I was busy dumping nearly my entire position while the stock was at its years’ high).

In terms of other liquidations, Pinetree Capital Debentures (TSX: PNP.DB) has continued to be redeemed and following their January 8 redemption will be an insubstantial fraction of my portfolio. This debt will most likely mature on May 31, 2016 with the remaining principal balance paid with 1/3rd converted into penny stock equity. Hopefully some of the larger debtholders can take their new-found equity and then requisition a special meeting to get some proper directors in place to monetize the rest of the shell.

The Canadian residential real estate market continues to be under pressure, with the new Liberal Canadian government not wasting much time early on in its administration to tighten the screws further on down-payment requirements on residential property valued at more than CAD$500,000. There is also significant fear in terms of the valuation of various real estate, including that in oil-linked Alberta/Saskatchewan, and the metropolitan areas of Vancouver and Toronto. Accordingly, Genworth MI (TSX: MIC) has been the worst performing component of the portfolio for the year, down approximately 25% for the year. If you do not believe that the real estate market in Canada will collapse anytime soon, it is trading in the deep, deep value range (trading more than a 25% discount to tangible book value).

Bombardier preferred shares (TSX: BBD.PR.B and BBD.PR.C) will have been my riskiest year-end investment. There’s still more in store with them that I do not wish to get into right now. The investment is currently in the black, although I wish I had bought more in the August liquidation spree that occurred. An investor hitting the buy button on August 18 or 19 was buying a 20% yield that should be trading at far less. Nobody wants to invest in them, which is one reason why they are likely a good investment at the moment.

A less risky way of playing them is purchasing their 2020 debt, which will give you a yield to maturity of about 13%. This is a very good return in our low interest rate environment in relation to the risk taken on the debt, but I am expecting Bombardier do much better. Simply put, if you believe they are going to succeed, you probably want a higher degree of exposure to their success than their debt as it appears to be a fairly binary situation.

I also took a material position (in both preferred shares and corporate debt maturing a few years out) of a company that is somewhat sensitive to the fortunes of the oil and gas industry. They have common, preferred and senior debt publicly traded on US exchanges. I bought the preferred cash stream of an organization that will be generating heaps of operating and free cash flows well into the future (to pay preferred shareholders), and it is senior to the payouts that are still being received by the common holders. The debt is of the same issuer, it is a senior unsecured debt issue that, upon maturity, should represent a CAGR of about 18%. There are huge incentives in place to ensure that both the preferred and senior debt holders get paid even in a very tepid oil and gas environment. This company is NOT Kinder Morgan.

I continue to hold minor positions in the debentures of three other issuers (two well known, one not-so-well known), combined consisting of about 5% of the portfolio.

The biggest mistake I made this quarter was one of omission – I badly messed up an entry into Data Group debentures (TSX: DGI.DB.A) when they plummeted for god-knows what reason to the mid 30’s in the second week of December well after they made their decision to catastrophically gut their existing shareholders in exchange for $33 million of debt relief. I was staring at the quotation on my computer screen thinking “What the heck is going on inside the company? Are they pulling the plug and doing CCAA?”, and just stood there like a deer in the headlights while KST Industries scooped them up and have made a killing. Fortunately my contemplated investment was going to be a very modest amount (about 1% of the portfolio), but that would have been an easy double of money. Oh well.

My ten-year track record is considerably better than the major indicies, while having substantial quantities of cash for the duration providing a drag at 0% yield in the interim. The 2015 calendar year was spent with roughly 1/3rd of the portfolio in cash on average.

Miscellaneous predictions

Here are a few predictions, in no particular order:

(I realize this post is dated slightly further into the start of the 2016 trading session which reduces the predictive impact of such statements since the markets have already moved in the direction stated).

* Canadian Dollar, Canadian interest rates, Canadian Economy: The Canadian dollar will slide to 65 cents sometime during the year. Currency depreciation (and specifically its effects on the economy) will be a considerable factor why the Bank of Canada will not reduce interest rates below 0.5% as it will become imminently clear that having a toilet paper currency comes at severe cost to the domestic populace. While most people will appreciate saving $5 or $10 on a fill-up of gasoline, they would gladly trade this for a monthly savings of hundreds or thousands of dollars in reduced import costs. Currency depreciation becomes less of a stimulus than in previous decades to the fact that countries such as Mexico have gotten extraordinarily better at manufacturing than Canada. In general, Canada remains a one-trick pony (natural resource exports) and the government will scramble to implement policies supporting nearly anything other than natural resource exports. Yes, this means Bombardier will get a lift.

* Crude Oil: Despite geopolitical chest-thumping in oil-producing states, overcapacity in relation to ambient demand will continue to put a lid on the price of crude oil. Less-leveraged smart producers will continue to survive by being intelligent about cost reduction rather than going for raw output. There will continue to be consolidation in the marketplace, but only after debt write-downs occur.

* Natural Gas: I expect this commodity to fare better, relative to crude oil. I do not expect any excitement in terms of price action. Natural gas is received better on the political end of things and will be less vilified than crude, which will facilitate the continued building of infrastructure that depends on natural gas (specifically peak load power generation). LNG export aspirations to east Asia continues to be a pipe dream.

* Vancouver Real Estate: The Yuan-CDN$ conversion, despite some minor depreciation by the PRC Government, will still lead to favourable conditions for capital migration to Vancouver dwellings (especially fee-simple lots, i.e. single-family dwellings). So unless if the PRC economy goes into recession (necessitating the liquidation of capital from foreign real estate back to the PRC), I do not see spillover into the Vancouver real estate market, which will continue to be dominated by foreign (mainly Chinese) investment.

* Canadian Real Estate in general: Despite media headlines and sob stories about mortgage defaults and price deflation in the Alberta and Saskatchewan markets, it will blow over with little financial consequence for the overall country.

* Canada Federal Budget: Despite the initial 2016 Budget headlines of a $19.4 billion deficit in the 2016-2017 fiscal year, it will become quite obvious through mid-year that the actual deficit will be larger (around the mid 20’s).

* US Federal Reserve: I do not expect chatter about another rate increase to commence until July at the earliest. If the US stock market begins to tank, a rate increase is much less likely. I do not expect the target fed funds rate to rise beyond 1% at year-end. In addition, if it gets to this point (which I doubt), I expect the federal reserve to reduce the size of securities held on their balance sheet by not reinvesting the interest proceeds of their various securities.

* 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.

Outlook and commentary

My first remark is going to be about index investing. I have been relatively convinced that there is still a general aversion of the stock market, especially stemming from the equity wipeout that occurred from 2008-2009 when a lot of people that were fully invested panicked and sold at a generational low point.

Now the name is about safety in numbers – which should actually be called safety through obscurity – if you invest in 500 stocks instead of picking a few, surely your portfolio will be safer! This is basically an excuse to invest in things that you don’t know of and have done no research on in the name of diversification.

When looking at stock charts, I mentally blank-out the 24-month period between July 2008 and June 2010. If you look at index performance over the past 10 years with this exclusion, you can see that the TSX has been treading water. The S&P 500 has done a little better, but their performance profile has been less than stellar compared to the returns available in the universe of stocks outside of the main indicies. If you see mutual fund literature start their stock charts from Januray 1, 2009, be very cautious!

With the advent of “Robo-investing” where people can just plug in a bunch of money in accordance to their risk profile and algorithmic selection in the requisite low-MER ETFs, passive investment vehicles are becoming quite dominant vehicles of marginal asset pricing – they will mechanically purchase and sell in accordance to their money flows.

What this means is a lot of money becomes concentrated in what I deem to be the “usual suspects” and there is considerably less focus on assets that are more obscure. In other words: think very carefully about investing in anything that is on a major index. They will likely be more volatile than recent past history will suggest.

This also has some other side effects that create liquidity opportunities in the reverse direction – when a particular segment of the ETF world is out of favour, you can sometimes see the effects of indiscriminate dumping of stocks (or bonds) in particular market sectors.

The parasitic nature of mechanical ETF investing will be creating a bonanza of opportunity for active investors that pick narrowly targeted niches of securities that have had the “sell at market” button pressed multiple times without discrimination of price. The goal is simply to be on the other side of the trade when the last bit of liquidation occurs.

My second remark is going to be about oil and gas. Almost every active investor I know of has been dredging the aftermath of the train wreck and seeing what sort of value can be plucked out of the various companies. In general, most of the companies that are not major (i.e. exclude Suncor, CNQ, etc.) are over-leveraged and have cost structures that are barely making money (if not losing it). 2016 will be the year that most high-priced hedges will have expired and it will be a race to see who’s balance sheets can survive to live another day.

While all of these companies have very leveraged linkages to the underlying commodity price, some will rise more than others in the event of a commodity recovery. Likewise, some will drop more if the underlying commodity price does nothing and there are recapitalizations and other dramatic maneuvers that will tend to dilute (if not wipe out) the existing equity holders.

Investors are likely to bet on a “regression to the mean” scenario and anticipate some sort of recovery in pricing. In the short run, I am not so optimistic of this and it would suggest to me that the bulk of the returns to be made in oil and gas (and related service stocks) will be in the fixed income securities of such companies, not the equity. High yield spreads have ballooned to massive amounts (for a good large-cap example, look at bonds of Chesapeake Energy) and while equity holders will disproportionately profit if commodity prices do go on a 2009-style rip upwards, the most probable scenario is that debt holders will be the sweet spot in the risk-reward spectrum.

My third remark will be about Canadian preferred shares. Those 5-year rate-reset preferred shares have gotten absolutely killed over the past few years as 5-year bond yields have consistently hovered at very low rates. I’m not so sure that we will be seeing much of a recovery and instead these preferred shares will end up being a cheap financing vehicle for those issuers.

My fourth remark is that it is still obvious that anything with a significant yield has a bid associated with the yield value rather than the underlying earnings potential of the company in question. There are plenty of examples of dividend cuts in the oil and gas field and when these cuts occur, the equity plummets with it – this is a sign that people were investing purely for yield as opposed for earnings value. If you must invest in such types of companies, make sure that you are not paying a yield premium!

Right now there is no “home-run” potential in my portfolio where I anticipating seeing a huge gain like I did in 2013 (where I made a very targetted and directed bet which clearly worked), but my intuition does suggest that I will be seeing similar 2015-type performance in the upcoming year. There are a few more items in the research pipeline which I can hopefully capitalize on better than what happened with Data Group, but we will see. Nothing would please me more than seeing some sort of opportunity where I can report an outsized double-digit gain.

Also, I believe that patience will be my best virtue for 2016. Despite my aversion to yieldy products, there is a lot of yield in my existing portfolio by virtue of the nature of the fixed income investments – only 4% of the 18% invested in equities is zero-yield!

There is a gigantic amount of cash currently in the portfolio that I will be carefully holding onto when opportunities unveil themselves. I don’t like this huge mass earning 0%, but nothing destroys capital more than investing cash for the sake of having it invested.

Note on Performance Report

I would like to clarify that the TSX index I am using for comparative purposes is the TSX Composite. The other index that is sometimes implied with the phrase “TSX Index” is the TSX 60. There is a very high degree of correlation between the two indicies. I have also included a comparison to the total return indices, which assume the reinvestment of dividends. The indicies represent a 100% investment in the relevant constituents and a zero cash position, while the Divestor Portfolio at times has had substantial amounts of cash. The goal has always been to invest funds in the best risk/reward situations and not aim for relative outperformance, although the overall strategy would be mostly pointless if it underperformed the largest index funds!

Divestor Portfolio - 2015 Year-End - 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)
10.0 Years (CAGR):+14.08%+5.05%+7.24%+1.44%+4.38%
2006+3.0%+13.6%+15.6%+14.5%+17.3%
2007+11.7%+3.5%+5.5%+7.2%+9.8%
2008-9.2%-38.5%-36.6%-35.0%-33.0%
2009+104.2%+23.5%+25.9%+30.7%+35.1%
2010+28.0%+12.8%+14.8%+14.5%+17.6%
2011-13.4%+0.0%+2.1%-11.1%-8.7%
2012+2.0%+13.4%+15.9%+4.0%+7.2%
2013+52.9%+29.6%+32.2%+9.6%+13.0%
2014-7.7%+11.4%+13.5%+7.4%+10.6%
2015+9.8%-0.7%+1.3%-11.1%-8.3%

End of Canadian tax season

The last chance to dispose of stocks on the TSX will be at 12:59pm EST on December 24, 2015. These trades will settle in the 2015 calendar year. The exchange is closed on December 25, 2015 and also December 28, 2015 (in lieu of the December 26 Boxing Day holiday). Trades conducted on December 29, 2015 will settle in 2016.

Our American cousins journal their trades for taxation purposes on the transaction date and not settlement date, so they have up until December 31 to make their last-nanosecond trading decisions for tax purposes.

I have been insanely busy lately dredging the recent trainwrecks (mainly relating to oil and gas) and have been finding material of value, hence I haven’t been writing much here.

The biggest gainer on December 22 market trading

I will predict the company with a market capitalization of at least $1 billion that will exhibit the largest percentage increase in market valuation on December 22. I am pretty certain of my conviction.

Unfortunately, the company is not publicly traded. It is very likely to be publicly traded one day.

The company is called SpaceX, run by the same genius that runs Tesla Motors (Elon Musk).

Yesterday, they launched a rocket into space. They have done this before and being a private firm, this was no small feat as it was only done before by government-funded/operated space agencies.

The next step in their cost-optimization is being able to get the first stage rocket back to earth in one piece. Since the first stage probably costs around a low 3-digit million amount to construct, you would save a lot of money recovering this piece instead of having it dumped in the ocean.

They managed to do this less than 24 hours ago. Watching this video (the re-entry of the first stage rocket starts around 32 minutes in) is amazing. You can read about their initial attempts here.

My university degree was majoring in physics. I do not believe most people can appreciate how truly difficult this is to get correct.

They still have to figure out some other non-trivial matters, such as how much metal fatigue becomes a factor when reusing rockets, and how to deal with various atmospheric and variable factors that inevitably will come into play when it concerns rocketry, but for the most part, they are very well on their way to total domination of the low-cost space launch market.

After this successful re-entry, if SpaceX was publicly traded, I would guess their market capitalization would be up by 50% in a single day, which will likely top the charts on an ordinarily boring Christmas-time trading day.

Dream Unlimited Preferred Shares

With the calamity hitting the preferred shareholders of Dundee Corp (of which I narrowly escaped), I have long noticed that their spinoff corporation, DREAM Unlimited (TSX: DRM) has a similar situation going on with their own preferred shares.

You will have to dig through SEDAR and look for a May 31, 2013 document that is 8783kb in size and go to page 60 of 141 in the PDF document for a legal definition of what these preferred shares are. They made it so convenient as the documents are not even made searchable with the usual control-F function on Adobe Acrobat.

They trade as DRM.PR.A and they are retractable by the corporation at $7.16/share, and redeemable by the shareholder at $7.16/share, in both cases with accrued dividends (7% coupon on a $7.16 par value). Redemption and retraction are given with at least 30 calendar days of notice.

Unlike Dundee Corp, there is no ability for DREAM Unlimited to sneak a shareholder-hostile proposal to scrap the redemption feature without a significant sweetener – if they did so, you can “vote” by exercising your redemption rights and get your money 30 days later instead of voting your shares against such a hypothetical proposal.

The only risk is the underlying corporation, DREAM Unlimited, elects to pay the redemption with common shares. The provision is 95% of the typical 20 day volume weighted average price scheme that is common to a lot of other offerings out there, or $2/share if this is the higher price. DREAM Unlimited common shares are trading at $7/share and with a market capitalization of $526 million, so a dilution of $36.7 million is not going to hammer the common shares below $2 if they tried an equity redemption – you’d likely be able to get out above par value in such an instance. The underlying business is not prone to “gap risk” (i.e. this isn’t some biotechnology company that will drop 70% one day due to a failed clinical trial), but it is in real estate development – this means that any of their properties that are not in Alberta or Saskatchewan, should be relatively stable (at least until you can get your redemption money in 30 days time).

In typical Dundee fashion, however, while the corporation is reporting considerable GAAP profits, their cash flow statements leave much to be desired. They do have ample liquidity in the meantime, having negotiated a $175 million million first-line facility with the banks expiring June 2018 and also $200 million of spare capacity on their operating line of credit which expires on June 2017. There is easily enough room to pay for a redemption of preferred shares – indeed, the fact that the preferred shares occupy a $36.7 million hole on their balance sheet probably forces them to be more conscious about this liability. I wonder why they haven’t even just bitten the bullet and redeemed this expensive capital.

In other words, the market value of this preferred share issue is going to be anchored around the $7.16/share mark as investors are able to skim off a 7% eligible dividend until such time the corporation bites the bullet and finally redeems the shares. If it goes too below $7.16, it is an easy arbitrage to buy below $7.16 and instantly redeem if you believe there is any sense of credit risk. It is as close to a risk-free 7% as it gets.

I note that the preferred shares were trading as low as $7.00 today and this was likely fueled by some investor out there getting his RBC Margin account spontaneously liquidated – it wasn’t a trivial amount either, around 40k shares worth. About 30,000 of them traded at $7.00 and somebody redeeming them back to the corporation at $7.16 made the easiest CAD$5000 on the planet. Ordinarily DRM.PR.A is not an actively traded stock and with all of the stress occurring in the marketplace, what may be “risk-free” isn’t as liquid as cold hard cash!

Anyway, I bought some shares at $7.00 today.

Revisit of Bombardier

There was an article on the Globe and Mail regarding my declaration that I had invested in Bombardier preferred shares (TSX: BBD.PR.B / BBD.PR.C).

I’m going to look very smart or very stupid at the end of this ordeal.

I will emphasize this is a high risk, very high reward-type opportunity. With high risk goes the chance for permanent capital loss, so the position size is appropriately small.

At current market prices, BBD.PR.B trades at a 12.6% yield, while BBD.PR.C trades at a 16.5% yield.

Other than the obvious business execution risk entailed within their aircraft division (specifically the execution of the C-Series project), there is another huge risk for investors: they will suspend preferred share dividends.

If this happens, BBD.PR.C will trade significantly lower (percentage-wise) than BBD.PR.B. The conversion risk is another component of the yield differential.

The comment about bond yields was accurate as of the middle of November, where after the government equity injections the short-term maturity bonds traded at reasonable yields. Today, however, yields have significantly widened, which also accounts for why the preferred shares are trading at such blowout yields.

Below is a graph of various yield to maturity curves of Bombardier debt (note these are NOT “yield to maturity” curves, I use a current yield + capital gain calculation which is non-standard but a more intuitive measurement for high yield debt I prefer using):

2015-12-14-BBDBondYields

The near-term maturities have risen to the 10% yield levels, which puts the corporate entity in the refinancing danger zone.

Considering how much equity was injected into the company (US$2.5 billion) over the past few months, this is not exactly an enthusiastic market for debt, especially their March 2018 issue which matures in just 2.25 short years from now (albeit this specific issue’s last trade was 98 cents on the dollar – but go back another 6 months and that one traded at 90 cents!).

Part of this is likely because of year-end dumping for tax reasons, and the embarrassment factor of any fund managers that are holding onto this – they don’t want those shares to appear on their year-end financial statements to clients!

However, there is also a very deeply political component to my investment thesis. The Quebec investments are part 1 of the story. I’m waiting for part 2 to resolve itself (and this does not involve a federal government investment – if it happens, it will be icing on the cake).

The point of maximum fear

Very interesting things happens to markets at bottoms and tops – there are typically panic spikes down and up.

My market instincts suggest that we’re approaching some sort of local maximum for fear in terms of the energy markets. All doom and gloom, and usually you hear about the opposite arguments (demand is rising, geopolitical risk, etc, etc.) but none of this is present.

Probably a reasonable time to shop for assets in entities that will be able to survive the trough.

Dundee Corporation – DC.PR.C – Series 4 Preferred Shares – Exchange Proposal – Analysis

Dundee Corporation (TSX: DC.A) has a preferred share series, Series 4, which trades as TSX: DC.PR.C. The salient features of the preferred share is a par value of $17.84, a 5% coupon, and a shareholder retraction feature which enables the shareholder to put the shares back to the company at par on or after June 30, 2016. The company has the right to redeem the preferred shares at $17.84 in cash or 95% of the market value of DC.A stock, or $2/share, whichever is higher.

I was going to wait for the management information circular to be released before definitively writing about this proposal, but my impatience got the better of me (in addition to me no longer being a preferred shareholder, which tells you what I think of the arrangement). James Hymas has written twice about this one (Link 1, Link 2) and his conclusion the was the same as mine when I read the arrangement: we both don’t like it.

Dundee announced they wish to change the terms of the preferred shares per the attached proposal as they do not wish to allocate what would functionally be a CAD$107.4 million cash outlay, puttable at any time by the preferred shareholders. The special meeting will be held on January 7, 2016 with the record date at December 3, 2015 (so shares purchased until November 30, 2015 are able to conduct business at the meeting with the typical 3 day settlement period).

Details of proposal

(ranked in my order from most important to least important)

1. Shareholder “put option” can only be exercised on June 30, 2019 (from the present date of June 30, 2016);
2. A consent payment for an early “yes” vote of $0.223 (one quarterly dividend coupon payment) and $0.1784 for the broker holding the shares!
3. Coupon goes from 5% to 6%;
4. Company will have redemption features above par (and at par at June 30, 2019) that realistically will not be triggered;
5. A “reverse split” at a ratio of 17.84/25 to adjust the par value of the preferred shares to $25/share making the math a little simpler;

The required vote is 2/3rds of the voting shareholders.

Analysis

Dundee Corporation is controlled by the Goodman family in a typical dual-class share structure. The corporation is a quasi-holding structure, with entities that are consolidated on the financial statements and some that are accounted for with the equity method. Thus, reading the income statement of the consolidated entity is not a terribly fruitful activity until one looks at the components. Most of the significant components are losing money. Considering that there are some heavy investments in oil and gas, and mining, this is to be expected. The best income-producing asset is the spun-off Dream Unlimited (TSX: DRM) which is a real estate development company. The take-home message is that the corporation as a whole is bleeding cash – about $25 million a quarter in 2015 to date.

Their balance sheet is not in terrible condition, but it is deteriorating – At Q3-2015 they reported $274 million in consolidated cash in addition to having a $250 million credit facility (with $93 million drawn) that expires in November 2016. However, most of the other assets are related to their heavy investments in the resource industry, which already received an impairment charge in Q3-2015, and likely to be impaired further.

So while it is very evident that Dundee will be able to pay their CAD$107 million preferred share liability when it is available to be redeemed on June 30, 2016 and beyond, the clause to extend the redemption date from June 30, 2016 to June 30, 2019 involves a pricing of significant credit risk over the incremental three year period, hence this deal being very unattractive for preferred shareholders – it is not entirely clear that the company will have any cash left to redeem the shares! The company does have the option to redeem the preferred shares in common shares of Dundee, but at this point the common shares might be worth under the CAD$2 threshold which is the minimum conversion rate.

Finally, the market does have valuation information on the other preferred share series trading – DC.PR.B and DC.PR.D – currently giving a 9% yield with no redemption possibilities – and this would suggest that the proposal of DC.PR.C, assuming a moderate “redemption” premium (i.e. with the shareholders receiving their money back in 3.6 years), would result in such shares trading at a minimum of 92 cents on the dollar, or roughly CAD$16.41 equivalent on today’s preferred share price (roughly a 4% price reduction on today’s CAD$17.00 trading price!). This assumes that there is equal “credit risk” with non-payment of dividends between now and the redemption date and no risk of receiving a lessened payment in 3.6 years – hence, 92 cents on the dollar would be a maximum valuation at present given market conditions.

Thus, the consent payment would need to be significantly higher than $0.223/share for preferred shareholders to be compensated for the extra three years of “holding risk” they are taking – my minimum estimate would be about $1.43/share for this to even be considered on par value, or $0.60/share when considering the existing market price of CAD$17. Taking the mid-point of this would be a $1/share consent payment. I would suggest that $0.60/share cash plus another $0.40/share in common stock be given for such a deal to be accepted. I’d love to see how the “fairness opinion” rationalizes this original deal being fair for shareholders – maybe fair for the company paying for the report!

Ethics

What is unusual about this proposal is that the intermediary (i.e. in most people’s cases, the broker that holds the shares) receives $0.1784/share that is tendered in favour of the deal. This clearly will create a conflict of interest between brokers and their clients. Ironically if that extra $0.1784 were applied to the beneficial shareholder, the proposal might have stood a higher chance of passing.

These tactics are clearly anti-shareholder and a huge red flag against management that would propose such a scheme.

Conclusion

My recommendation is that DC.PR.C preferred shareholders reject the proposal. It needs to be sweetened further.

I did sell all my shares between CAD$17.20 to CAD$17.44 on the open market last week and am happy to be rid of this headache.

For knife catchers only – Kinder Morgan

Kinder Morgan (NYSE: KMI) is in a chicken-and-egg situation. It needs financing to implement capital projects, but the cost of its financing has been steadily increasing due to its financing requirements.

Energy pipeline equities are a staple income producer for a lot of funds out there, but if they have their dividends threatened, the supply dump is going to be gigantic.

kmi

I sense this is a falling knife situation where it will be very difficult to predict the bottom. You can make an excuse for US$16.84/share being the bottom, or you can also make an excuse for US$9/share. It just depends on how many funds are hitting that sell button, irrespective of price.

Cash-wise, it is very evident they will have to cut their huge dividend. They are giving out US$4.5 billion a year and it is completely obvious they cannot sustain it given their capital spending profile (offset with their not inconsiderable positive operating cash flows). Refinancing their debt ($3 billion of it current as of September 30, 2015) is going to be progressively expensive as bond yields rise and their equity price drops. They do have a credit facility with $3.4 billion availability, but their buffer is thin!

I am sure Kinder Morgan will recover this financial earthquake, but how low will their common stock go before they recover?

Finally, let this be a lesson those that invest in highly leveraged industries (e.g. power generation, pipelines, etc.) – you never know when the market will arbitrarily pull the rug on your refinancing program.