Monthly Archives: September 2011

Petrobakken – plunging down

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While I have been losing a small amount of money on Yellow Media’s preferred shares jaunt to zero, fortunately I have steered far away from Petrobakken (TSX: PBN) which I have written here many times before.

They will not have an easy time renewing their credit facility which expires on June 3, 2012. The debtors are clearly in control of this one, just like how they are in control of Yellow Media. There is $1.14 billion in bank debt at the June 30, 2011 quarterly report. Another looming timeline is a US$750M debenture which holders have a put right – they give notice in December 2012 and the company must redeem at February 8, 2013.

(Update, September 29, 2011: Apparently they managed to renew their credit facility with an extra $150M in the facility… oops! This was announced in their Q2 financial update, which completely escaped me – this kind of blows a hole in the immediacy of cutting the dividend in the subsequent analysis, but there still remains a significant debt renewal of US$750M that will be taking place in February 2013).

From the MD&A, August 9, 2011:

As at June 30, 2011, PetroBakken had $1.14 billion of bank debt drawn on our $1.35 billion credit facility. Our credit facility is with a syndicate of banks and has a maturity date of June 2, 2014. The amount of the facility is based on, among other things, reserves, results from operations, current and forecasted commodity prices and the current economic environment. The credit facility provides that advances may be made by way of direct advances, banker’s acceptances, or standby letters of credit/guarantees. Direct advances bear interest at the bank’s prime lending rate plus an applicable margin for Canadian dollar advances, and at the bank’s US base rate plus an applicable margin for US dollar advances. The applicable margin charged by the bank is based on a sliding scale ratio of PetroBakken’s debt to earnings before interest, taxes, depletion, depreciation and amortization (“EBITDA”). The facility is secured by a $2.0 billion demand debenture and a securities pledge on the Company’s assets. The credit facility has financial covenants that limit the ratio of secured debt to EBITDA to 3:1, limit the ratio of total debt (total debt defined as facility debt plus the value of outstanding debentures in Canadian dollars) to EBITDA to 4:1, and limit secured debt to 50% of total liabilities plus total equity. The Company is in compliance with all of these covenants.

The TTM EBITDA is $659M, thus they are comfortably in compliance with this ratio. You would think the banks would be slightly uncomfortable with lending this much money in a company that is so heavy on capital expenditures.

My immediate guess is that the company will have to seriously curtail, if not outright suspend their dividend until such a time they are able to repay a substantial portion of their credit facility. This is not news to me – I had predicted this in May of 2011.

Another course of action they will likely implement is a slowdown of their capital expenditures. The only consequence of this, however, is that they will not be able to keep up their production levels, which their wells strongly taper off after the first year of drilling. This in turn will hinder their financial results.

The company is also highly sensitive to the price of oil and the past six months of WTIC trading has not helped their cause any.

Even though PBN has been sent down over 50% over the past couple months, it is still trading above my fair value.

Yellow Media restated credit facility – can they survive?

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As Yellow Media’s shares (preferred and common) continue their descent to zero, they did release what was in their restated credit facility (attachment).

Notably are the following:

1. Article 8 covenants are fairly obvious – the company must report annual and quarterly statements in compliance with GAAP, etc. There is a reference to budgets and projections (8.1 (c) and (d)) that will likely mean that the creditors will have material information that the public does not have. Probably the same people dumping the preferred shares well in advance of this calamity!

[8.1 (d)] (x) a breakdown of print and online revenues, (y) distributable cash flow and distribution calculations and (z) expected revenue drivers and which projections should be in a format consistent with the September, 2011 Projections.

Also 8.10 requires the company to include more guarantors to the creditor agreement which are subsidaries of the company.

2. Article 9 covenants are more restrictive. They prohibit the taking out of further debt unless if under the credit agreement, except for minor items including capital lease obligations no greater than $25M, and also other minor conditions including intra-company debt;

9.3 prevents the company from acquiring or liquidating companies without being able to satisfy the existing covenants on a pro forma basis;

9.4 requires the company to remit any proceeds above $25M in a sale to the creditors necessary to achieve compliance with covenants on a pro-forma basis;

9.5 is the salient clause – it prohibits distributions to common shareholders (except for the last 2.5 cent common dividend upcoming), but includes the following clause:

(iv) the Borrower may declare and pay dividends on the preferred shares of the Borrower existing as at the date hereof,

This would suggest, as long as the company can make its other covenants that the preferred shares will continue paying dividends.

The important covenants, the performance-related ones, are the following:

9.7 Consolidated Total Debt to Consolidated EBITDA Ratio
The Borrower will not permit the Consolidated Total Debt to Consolidated
EBITDA Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be greater than the ratio of 3.50 to 1.

9.8 Consolidated EBITDA to Consolidated Interest Expense Ratio
The Borrower will not permit the Consolidated EBITDA to Consolidated Interest
Expense Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be less than the ratio of 3.5 to 1.

9.7 is a stronger covenant than 9.8; using the first half of 2011 results as a measure of these two, the company’s ratios would be as follows:

9.7: EBITDA (12-month extrapolated, realizing this is a flawed extrapolation) $366.5M*2 = $733M, debt at June 30, 2011 is $2.39B, for a ratio of 3.26:1. There was a large amount of debt paydown for the Trader Corporation sale, but the larger risk is the EBITDA number.

9.8: EBITDA: $366.5M for the first half; $84.6M in financial charges for the first half, for a ratio of 4.33:1; the financial charges going forward will be less due to the repayment of MTN’s, but the obvious risk here is the decreasing EBITDA;

The raw math boils down to the following: Can YLO keep its head above the EBITDA water? With the Trader Corporation sale, the company will have about $1.7B in debt to worry about, which means that its ultimate concern is being able to generate about $480M in EBITDA on an annual basis (or less if it continues to pay down debt). At present when you extrapolate the trajectory that its EBITDA is declining (2009: $903M, 2010: $860M, 2011: $366.5M in the first half), can they level it off at about 40% less than its 2009-2010 run rate?

If so, the company can survive its credit facility. If not, there will be a default.

High risk, high reward.

The optimistic scenario is if they can stem the decay and be able to survive its credit facility – I would guess that the preferred shares in such a case would trade around $17-18 if there is clear evidence that this is happening. Obviously we do not see any of that evidence currently and the next quarterly report is just as likely to be brutal.

Students of history will also remember that when Nortel was going through its preliminary death throes in 2002, they were contemplating restructuring and their preferred shares went down to about $1-2 before finally coming back up again. I remember that quite distinctly although I never purchased into Nortel preferreds back then. The analogy is not appropriate to this case (different business, different situation) but what is salient is that low prices give high risk, high reward type situations – there are many scenarios where it is likely that the preferreds of YLO will go to zero, but there are plausible cases where they will rise again.

This is why you never ever put significant fractions of your portfolio into picks that are high risk like this one – keep the bets tiny. At this point it’s really tough to distinguish between investing and gambling. Just as a point of reference, if you put 2% of your portfolio into a play like this and it goes up 10-fold (which the low-probability winning scenario is for the preferred shares if the company actually manages to get its act together), that 2% position will be a 20% position at the end of the day if you do not rebalance.

Just remember the likely scenario is that the 2% goes to zero!

Got my hands bloodied up catching Yellow Media

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As I alluded to in an earlier post, catching plunging knives (in this case, catching plunging share prices) will leave your hands bloodied, and indeed this has been the case with Yellow Media.

They announced this morning that they will be suspending their common share dividend and also will be reducing the size of their credit facility to $500M, of which $250M will be paid off at $25M/year from the beginning of 2012 onwards.

This caused their common stock to plummet, but oddly enough, caused their preferred shares to drop equivalently, to the tune of 50%.

PR.C shares are down to $3/share, while PR.D shares are down to $3.08/share.

By slashing the common dividend, they will save about $77M/year in cash flow.

With the common share dividend gone, it will remain an interesting decision whether the company will decide to cut preferred share dividends. PR.A will cost the company $10.7M/year, but this will be alleviated when they convert them to shares in April 2012. PR.B will cost $7.6M/year, but this will also be alleviated when the company force converts them in July 2012.

PR.C is the next drain on cashflow – $13.2M/year, and PR.D is $8.5M/year. Both of these series are cumulative and can only be called by the company at par ($25) which is obviously not going to be happening with them trading at $3 over the open market.

The debentures are trading at 32 cents and represents a $13M/year interest expense for the company – these interest payments must be maintained otherwise it will constitute a default – a 20% current yield, but how long will you see those coupon payments being paid?

The real question is: how quickly is the company’s cash flow diminishing? This “decay rate” is the critical variable in determining how financially viable the company is going forward.

The company’s preferred shares are obviously a very high risk and high reward type situation if your assumption is that they are not going bankrupt and they will be able to level off their cash flows at a positive amount.

Berkshire and commodities

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Two observations – Berkshire announced that it will repurchase its own shares at no more than a 10% premium to book value. The stock went up about 8% in trading during the session to roughly this level. Book value is $163 billion, while the company has 1.649 million class “A” equivalent outstanding for a book value of about $98,850 per share. Add 10% and this gives a value of roughly $108,700 per share, not too far from the closing price.

I find this interesting simply because Warren Buffett is now a net seller of his own company and he is quite good at using his mouth to talk up or down the market when it suits his purposes – there tends to be a media aura that he is relatively altruistic. I am not convinced that Berkshire makes a compelling value as its analysis is not that easy – essentially an insurance operation with a series of fully-consolidated subsidiaries and a hodge-podge smattering of equity in various well-known companies (including Burlington Northern). When at the scale of Berkshire, the rules of engagement are considerably different since it takes forever to build and exit positions – not as easy as plugging in a market order to buy 100 shares of Microsoft.

The last time Buffett talked about buying back his own shares was when it was trading at $40,000 at the peak of the tech bubble. He graciously offered anybody that was willing to sell at that price can call him up and sell it to him at the prevailing bid on the NYSE at the time. Nobody took him up on that offer.

The other observation is commodity prices appear to have developed a “spike” on the charts. Observe the following:

Although I am hardly a technical trader, my best guess at this time is that the three commodities will head up for the rest of the week or so before declining again and “retesting” the bottom of that spike and likely trending down. There was clearly some sort of liquidation that has been occurring and the market is not that deep.

The close of the quarter

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Here are a few things I am asking myself – I do not think these are unique to myself at the moment:

1. How low can 10 and 30-year bond yields go? 1.81% and 2.87% are the current yields, respectively. Why would somebody want to lend the US government money at this rate when the entity they are investing in has its only escape route in debasing its own currency?

2. How low will commodity markets go? Copper has cratered about 25% over the past two months, silver has been taken out and shot in the past week, and even gold is starting to wobble. How much pain can investors in commodities take before they start getting cold feet and bail out en-mass more than they have done currently? My suspicion is that this is the beginning.

3. What should be on my watchlist that will do the best in the event of a recovery? In the 2008-2009 crisis I concentrated heavily on corporate debt investments, but I suspect that whenever the bottom of this market is hit that investors in equities that are zero yield will fare better.

Too many questions, not enough answers. My outlook still continues to remain negative and requiring defensive action and also of the belief that we will continue to see sharp rallies and even sharper declines. There still isn’t enough panic out there. Although VIX is a quantitative measure that a good sector of the population uses, there are some other metrics out there that still show there is complacency.

There is no safety other than in cash

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People looking for a safe outlet for capital in the marketplace are not going to see anything except in the form of cash and cash equivalents. Typically commodities were used for the safety outlet, but notably today we see that the S&P 500 is down about 2.8% and gold is down about 4.5%.

Notably, today is the first day where the safe haven of gold is getting compromised in a market downturn. Previously gold used to hold its own against down equity market action.

One day does not make a market, but this trend is something to watch.

Technically you also see safety in 30 and 10-year government treasury bonds (Canadian or US, take your pick), but getting a 1.8% yield for the next 10 years is quite obviously a temporary solution for capital. While this might work best for a fund manager, for an individual cash is much more practical.

Notably, the Canadian dollar got pounded over the past couple days – currency traders have seen a 4% decline in the Canadian dollar:

US dollar strength to a lesser degree has also been witnessed in other major world currencies, including the Euro and Yen.

I continue to remain very skeptical of the markets and am still in a preservation of capital mode – today is the first day in awhile that I’m looking at the dry powder keg and thinking of how I will be deploying it. But that time is not now. The only minor exception I made was in the preferred shares and debentures of Yellow Media (per my previous post) simply because the liquidation of those securities by its existing investors is a mostly independent event of the present market meltdown we are currently witnessing.

It is very difficult to be an index-beating active investor without the ability to side-step market crashes. By side-stepping crashes you can keep your capital freed up for those very brief and opportunistic time that the market is desperately asking for your capital. The market signals this to you with low prices, intense volatility, high bid-ask spreads and desperation. The last real time this happened was in late February/early March of 2009. There was a one week window of opportunity that you had where you could catch the bottom. It is very easy to identify in retrospect, but very difficult to get correct in real-time. Excessive outsized returns over a relatively short period of time (i.e. 200%+ returns on investment) can only be realized with ridiculously low entry points, which in turn requires financial nerves of steel to be the only buy hitting the “buy” button when the rest of the world is liquidating.

If your capital gets caught up in a market crash, it is a simple matter of mathematics to prove why you will not be able to gain much – in the 2008-2009 financial crisis, your average index investor was down 60% from peak to trough, which means in order to just break even you had to see a 150% return from the trough. If you can limit your damage to 10-20% of your portfolio and invest your capital at a more opportune time, it obviously will do wonders to your overall performance, just as how I nearly doubled my capital base in 2009.

A recent 21st century innovation is also that if you carefully analyze the tape, you will also see probable computer program traders that are set on a “fast liquidate” setting by relentless bid hitting. While it doesn’t have to take four years of electrical engineering education to perform a formal analysis of the trading signal, having some quantitative aptitude does assist in the process.

You can get a hint of what you are competing with simply by doing some mental work on how you would program such a trade algorithm, but Interactive Brokers conveniently has some simple algorithmic trade types that give you an idea if your mind blanks out.

It is time to do research on quality securities that will get needlessly hammered by a market downturn, but not nearly time to buy – yet.

Here’s a hint: I would not look at commodity companies.

Bloody hands catching the Yellow Media falling knife

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With the recent plunge of all securities of Yellow Media (TSX: YLO) I have decided to get my feet wet in purchasing a small mixture of the C, D preferreds and some convertible debentures.

Suffice to say, this is not a low risk investment. These securities are trading as if very, very, very bad things are going to be happening to the company, if not outright bankruptcy. The winning condition for an investor at these prices is that the company does not declare bankruptcy in the medium term future.

The business story is quite well known. The company is in the throes of a massive reorganization from print to digital and this has created tremendous risk.

The solvency of the company will be tested around the 2013 timeframe, when they face maturities of some of their Medium Term Notes and their credit facility. The upcoming maturities of the Medium Term Notes between 2013 and 2016 are the following (noting the values are as of December 31, 2010 – the company has repurchased some of these notes):

- $130 million of 6.50% Series 9 Notes maturing on July 10, 2013 priced at par, for an initial yield to the noteholders of 6.50% compounded semi-annually
- $125 million of 6.85% Series 8 Notes maturing on December 3, 2013 priced at par, for an initial yield to the noteholders of 6.85% compounded semi-annually
- $297.5 million of 5.71% Series 2 Notes maturing on April 21, 2014 priced at $99.985, for an initial yield to the noteholders of 5.71% compounded semi-annually
- $260 million of 7.3% Series 7 Notes maturing on February 2, 2015 priced at par, for an initial yield to the noteholders of 7.3% compounded semi-annually
- $387.4 million of 5.25% Series 4 Notes maturing on February 15, 2016 priced at $99.571, for an initial yield to the noteholders of 5.31% compounded semi-annually

Yellow Media Inc. has in place a senior unsecured credit facility consisting of:
- a $750 million revolving tranche maturing in February 18, 2013; and
- a $250 million non-revolving tranche maturing in February 18, 2013.

Notably, the credit facility has a covenant of a minimum ratio of Latest Twelve Month EBITDA before conversion and rebranding costs to cash interest expense on total debt of 3.5 times. Obviously if the financial performance of the company continues to dwindle they will be compelled to pay this off before the MTN’s. They have $636M outstanding on June 30, 2011 in these facilities.

The difference in capital structure between the preferred series and the convertible debentures is relatively minor – the debentures are $200M of face value (maturing October 2017) which have priority over the preferred shares. The higher price paid for the seniority is reflected in the fact that an investor is likely to continue receiving coupon payments (until if/when the company defaults on its more senior debt).

Finally, with the sale of Trader Corporation and the net proceeds of approximately $700M, the company will have further financial flexibility to maneuver around its credit facility covenants and be in a position to use its cash to repurchase debt. At current prices, such repurchases will be highly yielding – for example, if the company did a dutch auction tender for its convertible debentures at 40 cents a piece, every million dollars tendered would save the company from $162,500 of pre-tax interest payments.

The other trading note is that the PR.C series of shares has a slightly lower coupon than the PR.D series (6.75% vs. 6.9%), but the PR.D has typically traded at or lower than PR.C prices. There may be a liquidity premium as there are more PR.C shares outstanding. In addition, spreads are quite high until the computer algorithms put in very small bid and asks and since other algorithms are hammering the bid this tends to create quite a bit of price gapping. The last trading note is that every fund manager on the planet will be embarrassed to show these securities in their quarterly statements, so the “window dressing effect” will likely mean that they will be jettisoning their securities before the September 30th date (3 days for trade settlement means they will be getting rid of them by early next week). Since there is a lack of liquidity in the preferred series, this has resulted in dramatic price drops.

I anticipate the common shareholders are not going to be too happy when their dividend will get severely cut again and diluted by the preferred share conversions. However, the company will have to take these drastic steps to save itself and to de-leverage. Deleveraging is always a very, very painful process when it is forced.

I highly suspect that an opportune time to catch the falling knife is very close. Stocks are most volatile at their highest and lowest points and this appears to be a low frenzy. Time to get my hands bloody.

Cosmetic Issues

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Due to some unfortunate button-clicking coupled with some failed attempts at restoring a recent backup, the cosmetic layout of the site will be somewhat spartan (even more so than its usual spartan form) until such a time I can get around to putting in something more modern. Sorry for the inconvenience.

Hopefully most people using this site do so through their RSS readers (http://divestor.com/feed) and thus they will hardly notice anything.

Yellow Media

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Yellow Media (TSX: YLO) is an interesting case on how to value a company in an industry clearly in collapse (in this case, collecting advertising dollars by selling paper bricks known as phone books). They are trying to desperately diversify into the 21st century, but just like how newspapers have felt it very difficult to doing so with the same financial models in place, Yellow Media is also in an equivalent state. Although the company currently is cash flow positive, it is diminishing – the exercise in valuation is the future assumption of how rapidly this is diminishing and also whether there will be any flattening of the decay.

That said, the top-line operating cash flow number for the first half of 2011 was $199.6M vs. $293.5M in 2010; still a healthy amount of cash coming into the coffers. Common and preferred share dividends (at the annualized rate as of this writing) is about $118M ($59M for the half-year period at the newly reduced dividend rate), so there is currently room to accumulate cash and reduce leverage.

The company is quite heavily leveraged. As of June 30, 2011, senior to everything are the Medium Term Notes (with a varying series of staggered maturities) – $1,644M; and a $636M credit facility. Junior to this are the convertible debentures (TSX: YLO.DB), a $200M issue. The annualized interest bite on these securities is about $129M a year.

There are also four publicly traded series of preferred shares outstanding. Series 1 and 2 (YLO.PR.A and YLO.PR.B) have approximately 16.9M shares outstanding; these are convertible into YLO common at various dates at $2/share (or 95% of market value if YLO equity ever goes above $2.11/share). The principal value of these shares is $422M. The other series of preferred shares are perpetual with only a call feature (YLO.PR.C and YLO.PR.D) – both of these series give out a dividend and there are 13.6M shares outstanding, face value of $339M.

Yellow also sold Trader Corporation for a net $708M, which closed after the June quarter-end. During the release of this quarter, the company announced it was slashing its dividend from $0.65/share to $0.15/share and also stopping its share buyback so it can concentrate on repurchasing debt and preferred shares. At the end of August they have repurchased approximately $238M in Medium Term Notes, and some preferred shares.

A brief look at the valuation of the various securities – currently, the common shares are trading at 68 cents (giving the company a market cap of $348M, 511M shares outstanding). One item that is clear is that the common dividend is likely to not be sustained at the existing level – the $77M in after-tax cash flow out the window is going to be required to assist in the de-leveraging effort. Once dilution of the convertible preferred shares are factored in, another 210M shares will be added to the share count.

The convertible preferred shares are trading primarily as a function of the common shares (due to the fact that the company will likely convert the preferred shares into common shares as early as possible, especially as they cut the common dividend). This will save the company about $19M/year in after-tax cash flow. The perpetual preferred shares are trading roughly at 28 cents on the dollar (about $7 per share) and this translates into yields of over 20% – the risk is that the company will suspend dividends once they suspend the common share dividends. The market is obviously predicting that this will happen. If they do, they will save $22.4M/year in after-tax cash flow.

The next item on the seniority chain are the convertible debentures, which are currently trading at 41 cents. These convertibles mature in October 2017 (6 years to maturity), and have a 6.5% coupon, giving the debt a 15.9% current yield. Yellow cannot defer the interest payments or it will face default, so it is likely as long as the company has cash flow they will be able to pay interest on the debt.

The question for an investor is whether the company will be able to shore up its cash flow situation, and if so, whether it will be able to sustain indefinitely payments on its preferred shares or debt.

Interactive Brokers increasing margin thresholds

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Interactive Brokers is the best accessible brokerage with respect to margin. They are also exceedingly inexpensive (for Canadian currency, their rates are currently 2.5% between $0 and $100k, 2.0% for $100k-$1M, and 1.5% above that). I have not employed margin for quite some time, but others can borrow money at low rates. Considering the prevailing interest rates, others see it suitable to leverage by borrowing very cheap money and investing it into income-yielding securities, while skimming the few percentage points. That said, the securities that are now available to leverage from now has a market cap limitation of US$250M or above, as they announced today:

As a result of recent market volatility, please be advised that IB is increasing the margin rates on low capitalization stocks (currently defined as companies with less than $250 million in market capitalization). The margin increases will occur in three steps beginning on Wednesday, September 21, 2011 and ending on Friday, September 23, 2011. The margin rates will increase to 50%, 75% and 100% at the open of business on 9/21/2011, 9/22/2011 and 9/23/2011, respectively.

The current list of stocks which are subject to this margin increase is subject to change. The current list can be found on the following page:

http://ibkb.interactivebrokers.com/node/1788

Upon implementation, any of the incremental margin increases may result in a margin deficit in the account. A margin deficit implies that an account becomes subject to automated liquidation. Please carefully review the current positions within your account and adjust the portfolio accordingly.

I suspect the brokerage firm has done some risk analysis on customer profile accounts and has determined that the concentration within these low capitalization stocks has reached a point where they could not spontaneously liquidate the securities at an acceptable price in the event the stock market crashes. In such an event, the brokerage would be left to cover the remaining shortfall in the customer’s account (as presumably the customer will not be cutting a cheque back to cover such a deficit).

Interactive Brokers (Nasdaq: IBKR) is a very well-run operation and they probably did not make this decision lightly as it will be costing them some money.