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.

Canadian interest rates – probably level from here

The Bank of Canada “surprised” the market by increasing rates by a quarter point.

What I am feeling very regretful about is about a month ago I thought they were going to do it, but the BAX futures were assigning a rough 20%-25% probability of them doing it. I should have dipped my toes in there.

Readers of history (and it really feels like history since it happened such a long time ago) will recall that the last time they raised interest rates (from 0.25% to 1.00%) they did it in three consecutive meetings with three 0.25% rate increases.

The Bank of Canada clearly had a target in mind and contrary to what the talking heads on the media have to say about the matter, I think they will hold at 1% for the intermediate term. There are a couple reasons for this, but one is that their original policy stance to stay at 1% (before they dropped to half a point) is that the Bank of Canada has accumulated considerable research that ultra-low policy rates create their own risks by virtue of being so low. There seems to be “mean reversion” to this. The other is that the inflationary threat does not appear to be forthcoming at present, especially now that the Canadian export economy will be dampened by the increased Canadian dollar.

There is also the matter of bringing the short term rates up to a point where the spread between the short-term and 10-year bond will converge to nothing. The federal reserve is going to run into the same problem when their central bankers will be asking themselves a correlation/causation question of whether an inverted yield curve is a predictor of a recession, or whether an inverted yield curve causes one.

Markets are predicting a 70-75% chance that the Bank of Canada will raise rates by the end of the year. If this goes to 80% or higher I’ll probably take a bet against rate increases.

This brings me to my next point, which is the Canadian dollar. It has risen dramatically over the past three months.

In fact, the rise in the Canadian dollar has been my biggest portfolio “miss” over this time – it has generated a lot of paper bleeding since I keep my portfolio balanced between CAD/USD. The Canadian dollar has gone up 6.5% from July 1st of this year, and it has represented a 3.2% drag on performance quarter-to-date. My gut instinct says to increase my own position of USD but I am still reluctant to do so since the momentum of the Canadian dollar feels like it is stepping in front of a freight train. There is probably a logical point to do so (around 85 cents if it gets there?) but it is something I am acutely looking at.

An increase in my USD positioning will mean that my research will be more US dollar-focused. I have been focused on Canadian securities for a considerable period of time, but considering what bland opportunities I have found in domestic markets, it is probably a better for me to set my sights south for investment candidates.

TSX Bargain Hunting – Stock Screen Results

I’ve been doing some shotgun approaches to seeing what’s been trashed in the Canadian equity markets. Here is a sample screen:

1. Down between 99% to 50% in the past year;
2. Market cap of at least $50 million (want to exclude the true trash of the trash with this screen)
3. Minimum revenues of $10 million (this will exclude most biotech blowups that discover their only Phase 3 clinical candidate is the world’s most expensive placebo)

We don’t get a lot. Here’s the list:

September 1, 2017 TSX - Underperformers

1-Year performance -99% to -50%
Minimum Market Cap $50M
Minimum Revenues $10M
#CompanySymbolYTD (%)1 Year (%)3 Year (%)5 Year (%)
1Aimia Inc.AIM-T-74.89-72.74-86.9-84.6
2Aralez Pharmaceuticals Inc.ARZ-T-73.77-76.19-56.6
3Asanko Gold Inc.AKG-T-62.86-71.4-38.8-58.1
4Black Diamond GroupBDI-T-58.41-56.78-93.7-91.4
5Cardinal Energy Ltd.CJ-T-60.91-51.8-79.7
6Concordia InternationalCXR-T-42.81-85.24-95.6-69.2
7Crescent Point EnergyCPG-T-53.04-56.72-80.8-79.1
8Dundee Corp.DC.A-T-51.6-51.76-84.7-87.4
9Electrovaya Inc.EFL-T-42.72-61.8822201.2
10Home Capital GroupHCG-T-55.42-52.16-74.3-45.2
11Jaguar MiningJAG-T-54.31-62.14-55.8-99.7
12Mandalay Resources CorpMND-T-53.75-66.36-65.7-52.6
13Newalta CorpNAL-T-56.9-59.68-95.5-92.7
14Painted Pony EnergyPONY-T-64.97-60.94-77.4-65.9
15Pengrowth EnergyPGF-T-60.62-59.57-88.9-88.6
16Redknee SolutionsRKN-T-51.92-64.95-78.2-41.4
17Tahoe ResourcesTHO-T-53.04-66.27-78.2-66.9
18Valeant Pharmaceuticals Intl.VRX-T-15.25-56.68-87.4-67.3
19Western Energy ServicesWRG-T-61.61-55.09-88.6-82.7

Now we try to find some explanations why this group of companies are so badly underperforming – is the price action warranted?

1, 8, 10 and 18 are companies with well-known issues that have either been explored on this site or obvious elsewhere (e.g. Valeant).

2 is interesting – they clearly are bleeding cash selling drugs, they have a serious amount of long-term debt, but they have received a favorable ruling in a patent lawsuit against (a much deeper-pocketed) Mylan. There could be value here, and will dump this into the more detailed research bin.

3, 11, 12 and 17 Are avoids for reasons I won’t get into here that relate to the typical issues that concern most Canadian-incorporated companies operating foreign gold mines, although 12 appears to be better than 3 and 11. 17 has had huge issues with the foreign government not allowing them to operate their primary silver mine.

4, 13 and 19 are fossil fuel service companies.

5, 7, 14 and 15 are established fossil fuel extraction companies with their own unique issues in terms of financing, profitability and solvency – if you ever predicted a rise in crude oil pricing, a rising tide will lift all boats, but they will lift some more than others (specifically those that are on the brink will rise more than those that are not). 14 is different than the other three in that it is mostly natural gas revenue-based (northeast BC) which makes it slightly different than the other three which warrants attention.

6 If you could take a company that clearly makes a lot of money, and drown it in long-term debt, this would be your most prime example. It just so happens they sell pharmaceuticals. Sadly their debt isn’t publicly traded but if it was, I’d be interested in seeing quotations.

9 A cash-starved company selling a novel lithium-ceramic battery at negative gross margins would explain the price drop. Looks like dilution forever!

16 Lots of financial drama here in this technology company. They went through a debt recapitalization where a prior takeover was interrupted by a superior bid. Control was virtually given at this point and the new acquirer is using the company for strategic purposes that do not seem to be in line with minority shareholder interests. A rights offering has been recently conducted that will bring some cash back into the balance sheet, but the underlying issue is that the financials suggest that they aren’t making money, which would be desirable for all involved.

The progress of an inactive portfolio and irreverent thoughts on Cineplex equity

Since May, I have not made any trades beyond consequential ones stemming from the liquidation of KCG (which was bought out for $20/share).

This period of inactivity (three months) has been quite a dry streak in terms of transactional volume. My brokerage firms will probably not like it – the last time I had trade volume (in terms of commissions spent) this low was in 2012 (where my performance was +2.0% for the year). In terms of a fraction of assets under management, it is at a level where even Vanguard would blush at the expense ratio.

My portfolio, quarter-to-date, is up a slight fraction simply due to the resolution of the TK situation and offset negatively by the rise in the Canadian dollar. I’m a bit mystified at the rise of the dollar, but I’m guessing this is something geopolitical resulting from the actions of the US government administration.

One stock that caught the attention of my radar is the plunge in Cineplex (TSX: CGX):

I am going to be apologizing to all CGX shareholders in confessing that I am the reason why the stock price has crashed. The reason? On July 31st, I saw War for the Planet of the Apes at a Cineplex theatre. Graphics were great, but it was an awful movie! Sorry, shareholders!

I wrote over three years ago that I was mystified how the stock was trading so high when it is perfectly obvious that movie theatres are basically going the way of Blockbuster Video. I also do not like it how customers are relentlessly spammed for a good half hour before the actual movie is going to start – I think in our age of explicit advertisement avoidance, this is a net negative. As I wrote before, even at present price levels I would not be interested.

Overall market thoughts – volatility – fossil fuels

This is another rambling post with no coherency. The quarterly reports from companies are flowing in and I am reading them – but there are few companies that are below my price range where I start to care about them in detail. As such, my research pipeline at this point is in the exploratory mode rather than doing detailed due diligence.

It is in the middle of summer and I am not expecting much in the way of volatility – it is truly a summer where major portfolio decision-makers have decided to take away from the trigger switches.

Accordingly I have been sitting and watching with respect to my own portfolio while I do my casual research. Probably my biggest error of omission was watching the solar market rise over the past six months – I’d written them off, along with almost everybody else, as languishing when the price of fossil fuel energy dropped. A lost opportunity there – there was one company in particular which I earmarked, financial metrics looked great, but didn’t even pull the trigger, primarily due to insider selling. If I executed correctly on it, I would have been looking at a double now. Oh well.

An equity chart that caught my attention was the high expectations of investors of Canaccord pulling a great quarter, which came nowhere to fruition:

This is very obviously the chart of expectations crushed after a quarterly report – a regression to the recent mean would suggest a $4.50-ish stock price. I also notice their domestic competitor, GMP, being crushed after their quarterly report.

I also notice most liquid fossil fuel companies are getting hit badly and are close to multi-year lows. In the USA, most of the companies receiving boosts are the ones that have had been relieved of their debt burdens through the Chapter 11 process (LNGG is a great example of this). I still don’t think equity holders of fossil fuel extraction companies are going to be too happy over the next 12 months.

I also took notice with Interactive Brokers, and Virtu’s commentaries with respect to Q2-2017 as being one of the lowest volatility environments possible – they are two types of businesses that generate revenues as a function of trading volumes. Volatility correlates negatively with an increase with the broad markets – I am looking for defensive-type companies that will do okay in an environment like present, but will really do well when volatility increases.

Interactive Brokers is a classic example of a great company (they are the best at what they do by a hundred miles over everybody else), but one who’s stock I am not interested in buying at current prices.

Mostly everything in the Canadian REIT sector seems to be over-valued. An interesting trend is that the downfall of retail is somewhat being projected by RioCAN’s chart – trading below book value, it might seem to be an interesting value, but are they able to keep up occupancy and lease rates to businesses that have to compete against Amazon? The residential darling of the market is Canadian Apartment Properties (CAR.UN) but they are most definitely not trading at a price that would suggest a future performance beyond a high single digit percentage point and this is under the assumption that their real estate portfolio asset value remains steady. Trading in the entire REIT sector seems to be entirely yield-focussed which is never a good basis to invest, but it is a good basis to evaluate other investors’ expectations on these entities.

Gold has also been up and down like a yo-yo and might be an interesting bet against dysfunctional monetary policy. Unfortunately my ability to analyze most gold mining firms is generally not that fine tuned.

The liquidity of my overall portfolio is very high (nearly a quarter of the portfolio is collecting dust at a short duration 1.5%), but right now I don’t see much investment opportunity that would suggest avenues for outperformance. I could shove the money into some sub-par debenture (e.g. TPH.DB.F which buys you a 7% coupon until March 31, 2018 maturity) but do I really want to lock my capital into something that is questionable? It is the literal metaphor of picking up pennies in front of a steamroller. My policy is that if I have to force my money to work, chances are the investment decision’s risk/reward is worse than if I just held it in cash and waited for some sort of crisis to hit. I generally define “crisis” as something that will take the VIX above 30%, but it has been awhile since we last saw it:

It is pretty ironic how the election of Donald Trump was foreseen by most pundits to be the end of the world and higher volatility times, but so far the opposite has turned out to fruition. Will it continue? Who knows.

I see a lot of people making the mistake of impatience, and also the mistake of assuming that the index ETFs that they are investing into (Canadian Couch Potato, etc.) will leave them safe through masked diversification – works great as long as there are net capital inflows, but what happens if there is a correlated bust among these products? Will retail continue their conviction when they see a 10% drop in prices, or will they grit their teeth and add to their positions?

I continue to wait. It might be a very boring rest of the year with very limited writing. If you think you’re in a similar predicament, I’d love to hear your comments below.

Genworth MI Q2-2017: As good as it gets

Genworth MI reported their Q2-2017 results today and it was a blowout positive quarter.

The key statistic is that the reported loss ratio was down to 3% from 15% in the previous quarter – this is an accounting artifact due to the reduced reserving for losses (reserves increased $6 million compared to $30 million in paid claims). While the paid out claims is in-line with previous quarters, the difference is due to accounting for future losses – claims already in progress or claims processed have turned favourable from previous projections. The official explanation:

In the second quarter of 2017, losses on claims decreased significantly due to favourable development as there were fewer new reported delinquencies in Ontario, Alberta, Quebec and the Atlantic Provinces as compared to the incurred but not reported reserve as at March 31, 2017.

As a result, the company’s yearly guidance shifted from 25-35% loss ratio to 15-25%. Delinquent mortgages also slipped down from 2,082 to 1,809, a significant drop.

These two factors alone should be enough to boost the stock price 10% in tomorrow’s trading. Book value is about $41.34/share (which puts today’s closing price at 12% below book).

The only downside is that transactional insurance written is down 5% from the comparable quarter from last year. The portfolio insurance is down considerably but this was anticipated due to regulatory changes of the prior year. Accounting-wise, revenues recognized should continue to increase over the next few quarters as the amortization curve of the unearned premiums (previously written insurance) kicks into full swing.

Their portfolio is relatively unchanged by the increasing interest rate environment – their government and corporate debt portfolio is at a slightly decreased unrealized gain position ($100 million to $87 million), but their preferred share portfolio went from a $19 million unrealized loss to a $12 million realized gain position (which was a nice recovery from their initial investment).

One highlight which won’t get much press is that the company made a good chunk of change on unrealized gains on interest rate swaps from the last quarter. I’ve been tracking the CFO of Genworth MI, Philip Mayers, and the decisions Genworth MI has made on portfolio management has been very sharp.

The company’s reported minimum capital test ratio was 167% this quarter, and this is above their target rate of 160-165%, which means that the company may choose to engage in a share buyback or give out a special dividend if this condition persists – the upcoming quarter has a $0.44 dividend (unchanged) but the company is likely to increase this by 3-4 cents in the following quarter as they continue to build up excess capital.

All in all, this is probably the best quarter that Genworth MI has had in its history from an economic basis. Does it get better for them?

Canadian interest rate futures

There are three Bank of Canada announcements concerning interest rates for the rest of the year: September 6, October 25 and December 6.

Right now 3-month Banker’s Acceptance rates are 1.2%.

The BAX futures are signalling that there is a better than 50/50 chance that rates will increase 0.25% in the September 6 cycle, and that there is a slight chance of two 0.25% rate increases by the end of the year:

Month Bid price Ask price Settl. price Net change Open int. Vol.
Open interest: 942,178 Volume: 86,058
August 2017 0 0 98.765 0 0 0
September 2017 98.655 98.660 98.645 0.010 137,868 7,160
October 2017 0 0 98.615 0 0 0
December 2017 98.500 98.505 98.490 0.010 224,303 15,544
March 2018 98.395 98.400 98.375 0.020 163,606 19,552
June 2018 98.330 98.335 98.305 0.025 112,558 15,558
September 2018 98.270 98.280 98.250 0.030 120,395 10,055
December 2018 98.210 98.220 98.200 0.020 102,302 9,439
March 2019 98.160 98.170 98.140 0.020 45,030 5,208
June 2019 98.090 98.100 98.080 0.020 17,655 1,763
September 2019 98.010 98.030 98.010 0.010 10,774 827
December 2019 97.940 97.960 97.940 0.010 5,193 646
March 2020 97.860 97.870 97.870 0 2,199 198
June 2020 97.780 97.800 97.800 -0.010 295 108

Guessing the impact of these short-term interest rate changes I will leave as an exercise to the reader for now. The one salient fact, however, is that when short-term financing rates increase, the incentive to leveraging decreases and so marginal investments will be less viable. Parking cash in a rising-rate environment is best done with cash rather than using any debt instruments with duration (I wish I had stuck to this – my cash parked in VSB.TO has decidedly unperformed zero-yield cash!).

Teekay / Teekay Offshore / Brookfield financing

Brookfield Business Partners (TSX: BBU.UN) announced a $750 million investment (Brookfield’s release) (Teekay’s release) in Teekay Offshore (NYSE: TOO).

I’ve written extensively about Teekay Offshore and thought they would cut their distributions to zero and likely cutting their preferred unit distributions because of impending financing issues. This prediction turned out to be mostly incorrect – they are cutting their common unit distribution to 1 penny per quarter (down from 11 cents), and maintaining their preferred distributions.

In general, my expectations for the outcome for this pending recapitalization transaction have been worse than what materialized.

Not surprisingly, Offshore’s preferred units are trading considerably higher in the markets – up about 28%.

Teekay (parent) unsecured debt traded up to 98.5 cents on the dollar today – I am happy regarding this transaction – it is likely to mature at par (January 2020) or earlier via a call option. Offshore debt holders have even more reason to be happy – theirs are up from 82 cents to 97 cents, with a 7% yield to maturity. (On a side note, I notice somebody was asleep at the switch at 5:00am today – there was a $100k bond trade for 90.8 cents on TK unsecured, which was a steal for the buy-side – NEVER leave those GTC orders out in the open unless if you’re willing to scan the news before the market opens!).

Summary thoughts (apologies in advance for this not being in a more professional manner, I am not writing from my usual location):

The first chart is from their today’s presentation, while the second chart was from an early 2016 presentation. Compare the two:

1. With this equity injection, Offshore buys itself a couple years of time (which is what they desperately needed) – however, their debt leverage goes from “very high” to “above average” – slide 9 is considerably above what they were anticipating in their 2016 slide when they initially recognized the pending financial crisis. Pay attention to the Y-Axis of those charts!
2. Teekay dumps its $200 million loan to Brookfield for $140 million cash and 11 million warrants in Offshore;
3. It’s not entirely clear what the terms of these warrants are, or how Brookfield picks up 51% control of the GP (they get 49% of it right now);
4. Offshore’s financial metrics (cash flows through vessel operations) should start to improve, but I suspect there will be upcoming challenges as long as the oil price environment is not supportive (thinking counterparty risk, potential future contract renewals, pricing pressure, etc. – examining Diamond Offshore, TransOcean, etc., although not strictly in the same market as TOO, leads one to believe that the present environment is also not favorable to maintenance offshore oil production expenditures);
5. Teekay also liquidated their preferred unit holding in Offshore, and this is functionally a sell-off to Brookfield.
6. The creation of a “ShuttleCo” subsidiary of Offshore will create some more financial complexity in the operation – they probably want to spin this out for valuation and/or leverage purposes (as this division apparently is doing reasonably well).
7. Offshore’s operational challenges and risks are still not going away with this equity injection, but Teekay has more or less divested as much as they could from them.
8. Teekay also get relieved of guarantees from Offshore, which will improve its financial position dramatically in the event of insolvency (this is huge for Teekay unsecured debt holders). Teekay is functionally at this point a play on their LNG daughter entity, while having some minority economic participation in offshore.
9. Teekay’s cash flows through Offshore will obviously be curtailed significantly, they have their own vessel operations which are cash neutral, so they will be solely reliant on either equity distributions of Offshore (if they decide to fully liquidate) or LNG’s distributions.

If I was an investor in the preferred shares or debt of Offshore, I’d be taking gains right now and going elsewhere.

I remain long TK unsecured debt and do not have any intentions to sell – I took a full position back in them last year. I’m not keen on any of the equity.

Worst-performing portfolio components

The biggest hits my portfolio has taken this year has been with the appreciation of the Canadian dollar and the cash-parking vehicle of VSB.TO. Sadly (not including monthly distributions, which is about 5 cents a month) they’re down about 40 cents over the past couple months, due to the short-term rate curve rising considerably.

I take solace knowing that the increased Canadian dollar gives me larger purchasing power parity and the increase in interest rates in theory should make credit-sensitive assets cheaper to purchase.