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:

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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.

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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.

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.

Q3-2017 Performance Report

Portfolio Performance

My very unaudited portfolio performance in the third quarter of 2017, the three months ended September 30, 2017 is approximately +4.3%. The year-to-date performance for the 9 months ended September 30, 2017 is +24.2%.

My 11 year, 9 month compounded annual growth rate performance is +18.2% per year.

Portfolio Percentages

At September 30, 2017 (change from Q2-2017):

20% common equities (+0%)
26% preferred share equities (-2%)
30% corporate debt (-1%)
0% net equity options (-4%)
25% cash and cash equivalents (+7%)

Percentages may not add to 100% due to rounding.

USD exposure: 48% (-4%)

Portfolio is valued in CAD (CAD/USD 0.8019);
Other values derived per account statements.

Portfolio commentary

This was mostly an inactive quarter other than cashing in the remnants of KCG and making a minor debt acquisition purchase (this is net of the KCG debt redemption which also occurred during the quarter). The largest movement was not of my own action, but rather the appreciation in the Canadian dollar – going up from 77 cents to 80 cents on the dollar was a 2% drag on portfolio performance this quarter.

The portfolio was in line with the performance of the S&P 500 and TSX. I am somewhat disturbed by this “rising tide lifting all boats” market environment.

Also a minor unforced error on my part is putting idle Canadian cash into the short-term VSB.TO instrument in a very ill-timed trade over the past few months. This has been a minor, minor drag on performance (less than 10 basis points on the overall portfolio), but it should be a painful reminder to me that even the most safest of short duration yields can still contain price risk.

A minor error of omission is that I was planning on deploying a significant amount of cash on a particular US insurance firm as a result of mild panic trading from Hurricane Irma, but sadly it did not depreciate to my desired price level. This would have been an “invest and forget” type investment as I believe its management is top-notch and their capital management applications have equally been as such. I did actually own shares of this company more than five years ago.

I am happy, however, to sit on cash until I can figure out where to deploy it. My research pipeline is still relatively dry. Indeed, I have been investigating more on the short sale side of things than long.

Outlook

I’ve been examining the rise of the Canadian dollar and it is difficult for me to figure out. I’m generally of the impression that things will stall out at present levels (maybe up to 85 cents or so just strictly on technical momentum) simply because I do not see where foreign demand for Canadian dollars can come into play when we are simply not in a position to competitively facilitate exports of primary industry commodities. Almost every relevant government in this country is hostile to natural resource production and this leaves urban real estate as the other primary export. My policy to keep a range between 30-70% CAD/USD balance is still the most prudent course of action given my completely lack of investment edge on the currency situation or the lack of compelling alternatives in either currency.

I note with mild amusement that marijuana seems to be a hot sector again, with Canopy Growth (TSX: WEED) jumping over $10/share again during the quarter. Although I will not short them, I most certainly will not go long on them either. I find it incredibly fascinating how a commodity industry that will be controlled like liquor distribution could command a market value as if they were like the Microsoft of the marijuana industry (Microsoft earning monopoly-like margins on sales in their hay-day). It will not work this way for marijuana. Take a look at a miserable liquor store retailer like Liquor Stores (TSX: LIQ) for what the end-game of these companies are – even though WEED is involved in the production part of the value chain, most of the value is going to get extracted out from the regulatory protection aspects of marijuana distribution (in other words – taxes for money-hungry governments, paid for by both the consumer and companies alike). WEED’s insiders will make a fortune and should be commended for this, but third party investors will (pun definitely intended) go up in smoke.

I’ve also been eyeing what this year’s tax selloffs are going to be as this usually provides for a ripe picking ground for stocks that are force-sold in already weak conditions. There are two sector candidates for this type of action: retail and fossil fuel production.

Retail is getting annihilated by Amazon. I am contemplating whether there will be any traditional retail winners after retail’s transformation into a winner-take-all situation. I am barely seeing enough evidence that Walmart is getting its act together and should survive in some form, but I also question whether the space is big enough for Target to compete in as well. Smaller retailers are most certainly doomed unless if they specialize in a niche that cannot be commoditized by clicking or otherwise require an “in-person” presence to conduct. Has Sleep Country (TSX: ZZZ) peaked last July?

Fossil fuel companies deserve a bit of examination. Although they have spent the year in perpetual decline (the rise in the Canadian dollar has not helped them any, nor is the fact that getting oil to market has been severely hampered by government regulation), they are deserving of another examination. Crude demand, despite the media thinking that electric vehicles will make fossil fuel demand in terminal decline, is increasing and capital expenditure budgets will lag in the existing price environment. Eventually there will be a point where that supply-demand balance will tip – when this will be is anybody’s guess. There’s been somewhat of a revival in share prices in September, which obviously is some sector rotation going on with large funds.

In terms of expected future performance, if the quarter proceeds to fruition, I am expecting a 2% or so quarterly performance in the fourth quarter. Ideally, however, some sort of market crisis will hit and prices will go lower again. I’m not holding my breath – there’s just too much cash still sloshing around, looking to scrape a yield above the risk-free rate. As a result, the opportunity to make outsized gains is not in the current market environment.

Portfolio - Q3-2017 - 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)
11.75 Years (CAGR):+18.2%+6.2%+8.4%+2.8%+5.7%
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%
2016+53.6%+9.5%+12.0%+17.5%+20.4%
Q1-2017+18.6%+5.5%+6.1%+1.7%+2.2%
Q2-2017+0.6%+2.6%+3.1%-2.4%-1.6%
Q3-2017+4.3%+4.0%+4.5%+3.0%+3.5%

Genworth MI buying shares again

Genworth MI (TSX: MIC) filed with SEDI last week that they executed a share buyback in the month of August, purchasing approximately 913,000 shares at roughly CAD$36/share. This is nearly 1% of their shares outstanding. In light of the fact that they were making rumblings in filings a year ago with respect to the adverse consequences of increasing capital requirements with respect to the OSFI policy changes, this is most definitely a signal that they are now in an excess capital situation. The share buyback is at a discount of 13% to book value, so management cannot be accused of wasting value with this purchase (a rare characteristic that I very rarely seem managements of other companies perform when they conduct share buybacks).

Finally, Genworth MI traditionally increases its quarterly dividend rate in the third quarter announcement or announces a special dividend. The current regular quarterly dividend is likely to increase from 44 cents a share to around 47 or 48 cents. Management has a good track record of prioritizing buybacks when the share price is depressed to book or giving out special dividends when the share price is relatively high – I do not view a special dividend as being likely. Although my Genworth MI position is smaller than it used to be in the portfolio, it is a significant equity holding of mine and I see no reason to sell at this juncture, in absence of other opportunities.

Toys R’ Us – Looking back

Earlier in April, I said I was going to avoid Toys R’ Us unsecured debt. It was trading around 97 cents on the dollar at that time.

I looked at my quote screen today for lesser-attention securities and noticed they (October 2018 unsecured debt) was trading at around 56 cents on the dollar on reports that on September 6th, they decided to engage a bankruptcy firm to explore options. The bonds went down from 97 cents to 78 cents in a day, and they’ve straight-lined to their present trading price (53 cents and dropping as I write this) a week later.

I ask myself from the perspective of credit analysis – is there any hope for unsecured holders? The easy answer here is going to be no – I count at least $3.5 billion that is either “secured” or asset/real estate based loans out of a total of $5.2 billion in debt. Although their credit facility is about half-tapped (i.e. they’ve got time to structure a restructuring), I find it unlikely that they’re going to wait around until October 2018 and pay off that particular unsecured issue. The advantage of going into Chapter 11 prematurely is simple – they can offer the unsecured creditors (lease landlords, etc.) an unfavourable “take it or leave it” type deal (see yesterday’s post on Seadrill), be able to shed their high-cost items (including conversion of their unsecured debt into a token amount of equity) and move on with life.

There is one reason, however, why this may not happen:

Although Toys R’ Us equity is not traded on an exchange, it is a publicly reporting entity. Bain Capital owns 32.5% of the corporation. Are they willing to give up this equity? I’m guessing their own private valuation of the entire firm is small in relation to the amount of debt that would have to be paid back (if Bain wishes to keep control).

Also if Bain controls most of the secured debt, their interests lie with Chapter 11 instead of keeping control of the firm (via their 32.5% equity stake).

I find this one difficult to judge, but I would weigh on the side of a restructuring that will involve a material impairment of value to unsecured bondholders. There’s just simply too much secured debt and I do not think they will hold Chapter 11 back a year and a month just to pay the US$208 million that’s due with this specific obligation (there are too many others that will be due as well). This is especially true considering the overall entity is not producing a lot of cash.

All in all, I’m glad I avoided this instead of reaching for yield and getting burnt (which would be the only explanation why somebody would have invested in Toys R’ Us unsecured debt in the first place).

Seadrill Chapter 11 details

Seadrill, a publicly traded company that does offshore oil drilling, filed a Chapter 11 arrangement. The salient terms of the pre-packaged deal are:

The chapter 11 plan of reorganization contemplated by the RSA provides the following distributions, assuming general unsecured creditors accept the plan:

• purchasers of the new secured notes will receive 57.5% of the new Seadrill equity, subject to dilution by the primary structuring fee and an employee incentive plan;
• purchasers of the new Seadrill equity will receive 25% of the new Seadrill equity, subject to dilution by the primary structuring fee and an employee incentive plan;
• general unsecured creditors of Seadrill, NADL, and Sevan, which includes Seadrill and NADL bondholders, will receive their pro rata share of 15% of the new Seadrill common stock, subject to dilution by the primary structuring fee and an employee incentive plan, plus certain eligible unsecured creditors will receive the right to participate pro rata in $85 million of the new secured notes and $25 million of the new equity, provided that general unsecured creditors vote to accept the plan; and
• holders of Seadrill common stock will receive 2% of the new Seadrill equity, subject to dilution by the primary structuring fee and an employee incentive plan, provided that general unsecured creditors vote to accept the plan.

This is one of those strange instances where the common stock was trading like something terrible was going to happen, but in relation to its closing price Monday, they received a relatively good “reward” out of this process, 2% of the company (compared to zero if creditors take this to court).

The question is whether the unsecured debtholders will agree to this arrangement – my paper napkin calculation suggests that bondholders will get about 10 cents on the dollar (probably less after the “subject to dilution” is factored in) compared to the trading around the 25 cent level before this announcement.

Their alternative is that if they vote against the deal, the secured creditors will receive everything.

Please read the Pirate Game for how this will turn out and also a lesson on why being an mid-tier creditor in a Chapter 11 arrangement that requires all capital structures to vote in favour of the agreement can be hazardous to your financial health.

I will also note that Teekay Offshore effectively went through a recapitalization, and this leaves Transocean and Diamond Offshore that both in relatively good standing financially.

Want to make a few pennies? Temple Hotels Debentures

This is a bet on the confidence of your fellow investors to vote against a bad deal.

Temple Hotels (TSX: TPH) is a borderline-profitable hotel operating company. Financially they are in miserable condition. They have mortgages that are in covenant default, loads of debt and other issues (being in the wrong geography at the wrong time).

For whatever reason (still can’t figure it out today), on December 2015 Morguard Corporation (TSX: MRC) decided to take them over (via control of the asset management agreement) and recapitalize the corporation with equity capital through a rights offering. They used the funds ($50 million) primarily to retire about $60 million in convertible debentures in cash. Morguard owns about 56% of Temple’s stock.

Temple still has about $80 million in convertibles outstanding (TPH.DB.E, TPH.DB.F), and $45 million of it is about to mature on September 30, 2017. Yes, that’s in about three weeks.

Looking at their June 30 balance sheet, they have $14 million in cash and the Morguard parent would need to pay up. (I’ll note at this point the busy Canadian summer hotel season will produce about $7 million in operating cash flow, but this is not including mortgage principal payments and maintenance capital expenditures which would bring this figure down a little).

Management, therefore, is floating a proposal to extend the maturity of the debentures 3 years to September 2020. The terms are to keep the interest rate the same (7.25%), decrease the conversion price to something astronomically high ($40.08/share) to something very high ($15/share, or something that’d need to more than triple in order to get at-the-money) and do a 5% redemption at par at the end of the month.

In other words, they are offering nearly zero incentive for debenture holders to extend.

Indeed, management is continuing a practice that the Securities Act should ban, which is the payment to third-party dealers to solicit YES votes in proxies:

Subject to certain terms and conditions described elsewhere in this Circular, the Corporation will pay a solicitation fee equal to $7.00 per $1,000 principal amount of Debentures that are voted FOR the Debenture Amendments, payable to the soliciting dealer who solicits such proxy or voting instruction voted FOR the Debenture Amendments, subject to a minimum fee of $150.00 and a maximum fee of $1,500.00 per beneficial owner of Debentures who votes Debentures with principal value of $10,000 or greater FOR the Debenture Amendments. No solicitation fees will be paid to the soliciting dealers if the Debenture Amendments are not approved by the Debentureholders at the Debentureholder Meeting.

Insiders own 2.49% of the debentures. The vote requires 2/3rds of those voting to pass and a minimum quorum of 25% (which should be attained).

So this becomes a test of whether your fellow debtholders are stupid enough to vote in favour of this agreement or not, and also a function of whether you believe Morguard will back up Temple in the event that this proposal fails. You would think Morguard would provide some debt credit to Temple because otherwise why dump the tens of millions of dollars into the corporation and just have it get thrown away with a CCAA arrangement at this stage? Or have they decided that the salvage operation they are currently conducting is negative value and basically want to throw away this asset?

Since the TPH.DB.E series is trading at 96.5 cents on the dollar, it means that if you bought $1,000 par value you’d be looking at a 3.6% gain in three weeks if the proposal is rejected (it is too late for management to exercise the share conversion option) AND that Morguard gives capital into Temple to pay off the subordinated debt (nobody else would be sane enough to do it without ridiculous concessions).

The risk/reward is isn’t high enough for me to take the risk but I’m floating this one out here for the reader if you are!

Will Hurricane Irma cause insurers to drop?

Hurricane Irma is looking like it will blast a path through most of Florida in just over two days:

The media is making it look like that it will be apocalyptic. Indeed, the island St. Martin (famous for having an airport where you can sit on a beach and look up about 100 feet and see a landing Boeing 777 jet) was nearly annihilated. Right now Irma is one of the strongest (if not the strongest) in recorded history, but the question is where it will strike landfall in Florida (if there) and how much it will dissipate by that point – 75 miles can make a material difference in the damage calculation. If it goes through the heart of Miami, there will be tons of damage, but if goes through the western part of the peninsula, there’s a decent chance that the winds will slow down sufficiently by Tampa to still cause a lot of damage, but not the insane amounts the media is making it to be.

Thus while the media hype is overwhelming, the markets are treating certain insurers like the catastrophe is already a done deal, which may not be the case.

This is the classic information mismatch that creates market opportunity.