Harvest Energy Trust takeover by KNOC approved

The takeover of Harvest Energy Trust, for $10/unit and acquisition of debt by the Korean National Oil Company (KNOC), has been approved by Harvest Energy unitholders. The vote was 90.2% in favour. They required 66.7% for approval.

One particular note of amusement is the Harvest Energy Yahoo message board that was dominated by trolls were screaming about voting against the merger. If you believed that the message board was a representative sample of the unitholders, you would have received the impression that the takeover vote would have failed 90% against, instead of in favour! Message boards for most companies are worse than useless – the information that travels through them should be regarded with the same credibility of that of supermarket tabloids.

Retail investors generally do not matter in terms of corporate governance – it is the institutional investors, primarily mutual, pension and hedge fund owners that control most of the votes in publicly held corporations. The market had priced in Harvest units as if the takeover vote was a done deal, and indeed, the market was correct on this projection.

Once the takeover is finally cleared, with an expected date of December 22, 2009, Harvest will be delisted. My guess why they do this at the end of the year, opposed to the beginning of January is because so many people have accrued losses on Harvest Units that management decided it was worth crystallizing the capital losses for the 2009 tax filing, rather than deferring capital gains for 2010.

Within 30 days of the takeover, KNOC is obligated to make an offer to the debenture holders for the cash repurchase of debt at 101% of par value; I will be tendering my debt (or selling it on the open market above 101%, whatever the case may be) simply because of uncertainty of being able to be paid out. While I have glossed over KNOC’s financials, and believe them to be a very solvent and viable corporate entity, the information I have on them is not timely, they do not report to SEC or SEDAR, and I don’t want to have to deal with a Dubai-like situation where Harvest Energy defaults on its debentures, and KNOC will not guarantee the debt.

I am quite happy to tender the debt in 2010 as this way I can defer capital gains until I file my taxes in April 2011.

Dubai gets bailed out… sort of

Abi Dhabi decided to bail out Dubai, by providing a $10 billion equity injection. This was presumably after the insiders bought back a ton of Dubai debt (which was trading below 50 cents on the dollar and post-announcement is around 70 cents). About $4.1 billion of the equity injection is earmarked for repayment of maturing Islamic debt, while the other $5.9 billion is going toward paying contractors and other working capital needs.

My quick guess is that the Islamic debt gets paid off first to avoid any judicial inquiry on what happens to investors in such debt – i.e. whether they will get a stake in a reorganized company. The conventional debtholders (where there is an active secondary market) are going to be at the mercy of the Dubai courts; I doubt they will be getting any favourable treatment. Maintaining the perception of confidence in the Dubai debt system is crucial for Dubai if they are to retain any foreign institutional investors, and inevitably whatever settlement coming out of the Dubai debt default will be precedent-setting.

I decided to look up what Islamic Debt was, and the Wikipedia entry on Sukuk was rather enlightening – it seems that it has characteristics of zero-coupon debt. That said, I have no idea who would ever want to invest in such financial instruments – at least when investing in Canadian or US debt instruments, you would likely have a better chance in bankruptcy court than you will in Dubai (General Motors notwithstanding!).

(Update: Apparently this is not an equity injection, it is debt.)

Taiga Building Products notes

I was doing some research on Taiga Building Products subordinated notes (TBL.NT, coupon 14%, due September 2020). The amount outstanding is $129 million face value. They are trading around 49 cents on the dollar so this is obviously in the distressed debt category – the yield to maturity calculation is an irrelevant figure (32%). The debt traded as low as 17 cents (if it did so today, the yield to maturity would be 103%). Yield to maturity is a misleading figure because it assumes coupons can be reinvested at a rate that is at the YTM. This will obviously not be the case.

In early 2008 the notes were trading very close to par value. Around October 2008 they went below 90 cents and never came back.

The first thing that struck out at me is that any company willing to shell out debt at 14% is a high credit risk. They issued the notes in September 2005.

The equity is around 41 cents, at 32.4 million shares outstanding this is a market capitalization of $13.3 million. This would rule out any debt-for-equity swaps, at least outside the context of bankruptcy proceedings.

The other salient detail is that they deferred interest payments up until September 1, 2010. This is also conveniently the date where their revolving credit facility ($53 million) becomes due. This essentially means that the credit facility gets paid off first (as it is secured by various assets of the company) and then the noteholders will get the second stab at the company.

Looking at their financials, Taiga is a profitable company, but they are not generating net income nearly as quickly as they need to in order to pay off the debt by September 2010. They generated about $11 million in free cash flow for the first 6 months of their fiscal year, but this will likely moderate for the rest of the fiscal year. Their balance sheet is in rough shape, with equity at negative 82 million and a significant chunk of debt due in less than a year. If I was a creditor to Taiga I would be somewhat concerned as the September 2010 debt payment date comes closer.

The value of the notes strongly depends on whether they can refinance their credit facility. Presumably the company would be in better financial shape if they paid off their 14% notes and refinanced the amount for a lower rate of interest.

That said, the market right now is not going to let the company do that.

It is essentially a gamble to decide whether Taiga will be able to refinance. My bet is that they will not be able to without giving some sort of concession on the interest rate, plus an equity stake in the company. It will be very expensive for shareholders and the company in general. It is clear that Taiga can be a sustainably profitable company, but it has simply taken on too much debt – my unprofessional estimation would be that it needs to go down to about half of existing levels.

As such, I wouldn’t touch the notes at current values.

Dubai World default a lesson on foreign investing

I do not have any exposure to equities or debt outside of Canada and the USA, but I have been watching with fascination the fallout with respect to the default of Dubai World. Although most of Dubai’s investor base is European, it should have a small ripple effect around the world in absolute terms, but in psychological terms should reinforce that unmitigated speculation in real estate properties in might have adverse consequences in the future.

The parallel analogies between China (which one could argue has sufficient economic growth to warrant such capital investment) and Vancouver (which continues to mystify almost anybody that tries to perform a rational valuation on most properties) is obvious. However, even Vancouver does not have the excesses that Dubai did, mainly valuing waterfront properties so highly that they are to be reclaimed from the sea (or here). Looking at these projects makes me wonder what the monthly “strata fee” would be for one of these strips of land – just the costs to make sure that your island is not reclaimed by the Persian Gulf must be huge.

Financially, what is more complicated for investors is the lack of any idea of how subordinated their debt is, and what guarantees, if any, are embedded in the debt financing that was used to build such structures. The closest governmental analogy is that Dubai is a municipal government, while Dubai is one of seven divisions of the senior government, the United Arab Emirates (UAE). That said, the UAE (and the government of Dubai) made it quite clear that they will not be guaranteeing any debt of Dubai World, which means investors are hooped and can only claim whatever embedded asset value there is in the properties. This is even assuming the corporation follows whatever legal rules that are available to foreign investors in the UAE or Dubai.

It is these legislative nightmares that keep me clear away from foreign investments. In order to have a true grasp of the risk that one takes while investing, one needs to know the legal framework of the jurisdiction in question. Good luck trying to figure out Dubai World.

That said, China has gotten to the point where one might wish to more intensively study how their corporate legal structures work – from what I can tell, signed contracts and written documents are guidelines, opposed to binding, which makes analyzing social frameworks a much more relevant avenue than here in North America.

Limited Brands Reports Q3 results

I will begin this post by saying I don’t understand the shopping mall experience. Perhaps because of my gender, I just don’t understand why people, usually women, like to “go shopping”.

However, I can understand what goes before my eyes, and that is people shop. I might not understand fashion retail, but I understand the economics of it – something about the marketing works. It gets people to pay more for a product that inherently has very low marginal cost to purchase. The embedded marketing costs, however, are huge.

Earlier this year, I invested in some corporate debt of Limited Brands (NYSE: LTD) – the 2033 series of debentures, which has a coupon of 6.95%. Investors back then assumed that retail was going to get thrown out the window along with the rest of the economy and especially for a discretionary retail shop like Limited Brands (their primary brand name is Victoria’s Secret), droves of people would be not shopping for lingerie. Or will they? According to their last quarterly report, they are on track to bringing in about $500-600M in free cash flow, depending on how the Christmas season works out.

For 35 cents on the dollar, I figured that the debt would be a good buy. It was tough to rationalize how being rewarded 20% interest a year (plus another 4% capital appreciation) under the assumption that Limited Brands would not blow up could lose money. And indeed, it has not lost capital – the same debt is trading for around 71 cents if you shop around carefully. This will still net you 10% a year in coupon payments, and about 1.5% a year capital appreciation compounded over the next 23.8 years.

If you look at their balance sheet, they have about $2.9 billion in debt, covered by $968M in cash, and positive earnings. Although I have no idea whether the retail chain over the next 23.8 years will survive, at least right now it is looking quite good.  The following is the debt maturity schedule from the Q2-2009 SEC filing, which shows they have staggered out their debt financing fairly well:

15. Long-term Debt

The following table provides the Company’s long-term debt balance as of May 2, 2009January 31, 2009 and May 3, 2008:

May 2,
2009
January 31,
2009
May 3,
2008
(in millions)
Term Loan due August 2012. Variable Interest Rate of 5.18% as of May 2, 2009 $ 750 $ 750 $ 750
$700 million, 6.90% Fixed Interest Rate Notes due July 2017, Less Unamortized Discount 698 698 698
$500 million, 5.25% Fixed Interest Rate Notes due November 2014, Less Unamortized Discount 499 499 499
$350 million, 6.95% Fixed Interest Rate Debentures due March 2033, Less Unamortized Discount 350 350 350
$300 million, 7.60% Fixed Interest Rate Notes due July 2037, Less Unamortized Discount 299 299 299
$300 million, 6.125% Fixed Interest Rate Notes due December 2012, Less Unamortized Discount 299 299 299
Credit Facility due January 2010 15
5.30% Mortgage due August 2010 2 2 2
Total 2,897 2,897 2,912
Current Portion of Long-term Debt (7 )
Total Long-term Debt, Net of Current Portion $ 2,897 $ 2,897 $ 2,905

Another similar corporation that is debt-free is Abercrombie and Fitch (NYSE: ANF), which seems to defy everybody’s expectations during recessions by coming back from the financial netherworld to make insane amounts of money. I can see the appeal of Victoria’s Secret – sex sells – but Abercrombie? When walking into the two stores to do some ‘consumer research’, I just don’t understand what keeps these names afloat in the retail fashion world.

However, I can at least invest and make some cash off of it while the going is good. Will I know when it is time to liquidate? Who knows.