Sacha Peter – Page 2

Canada Convertible debentures – near maturities

The issuer market for Canadian TSX-traded debentures has been very muted. In past times, issuers would typically roll over debt with 6-12 months remaining in maturity by issuing new debt and calling the soon-to-mature issue. Today, these rollovers have been exceedingly rare, presumably because everybody and their grandmothers have been waiting for lower interest rates!

We have the following issuers that have maturities coming in less than three months, coupled with some point form notes:

AD.DB – Alaris – Likely to mature for cash, paid for with room in the company’s credit facility
AFN.DB.F – Ag Growth – Likely to get rolled over with a new issue – AFN.DB.J (3.7 years out) is 16% away from the money and is trading at 108, it is likely they can get an acceptable coupon price… AFN.DB.G is not further away with a year-end maturity and both might be done with a $150 million or so debt offering (disclosure: I own some shares here).
AI.DB.C – Atrium MIC – will likely mature and be paid by the bank line of credit
ALC.DB.A – Algoma Central – will mature for sure, the question is how much will get converted to equity? (they are 2% in the money at present)
EFN.DB.B – Element Fleet Management – will be converted to equity (conversion is well in the money at present)
TF.DB.C – Timbercreek Financial – will be paid off with the secured credit facility

With the possible exception of Ag Growth, all of these debentures will vanish from the TSX and be absorbed.

When examining the overall debt market (and also the preferred share market), very little strike me as potentially interesting. The price inflation in relation to potential risk is quite unattractive to me at present – the companies trading at low prices are generally doing so for very good reasons. They are also competing against risk-free cash at around 5%, which does not make their relative valuations look good – why aim for a risky 7-8% when you know that the liquidity associated with that 7-8% will be crap when there is a real market crisis, when you can just sit on your rear end with a safe and liquid 5%? I’m not reaching for yield – not being paid enough.

Modelling commodity companies

I’m not much of a technical analysis guru but here is my depiction of the trendline of Cenovus Energy (TSX: CVE):

Will this go on forever and end the year at $70/share? I wish, but incredibly unlikely unless if we’re heading into Weimar Republic inflation.

Despite this price rise, the company is still relatively cheap from a price to free cash flow metric. You don’t need to have a CFA in order to do some basic financial modelling:

This is from their IR slides and they will be spending $4.8 billion on capital expenditures in 2024. At “Budget”, which is WTI US$75, and US$17 differential to WCS pricing, the company will do roughly $10 billion in operating cash flow, leaving $5.2 billion of it free. They also have a sensitivity of $150 million per US$1 of WTI.

Everything being equal (it is not, but this is a paper napkin modelling exercise), at today’s closing price of WTI at US$86.75, they’re looking at a shade just under $7 billion in free cash flow. It won’t be quite this high in reality, but that puts the company at around 8.5xFCF to EV even at the current price. If you were smart enough to buy it at $20/share back in mid-January, at the price of WTI then (US$72/barrel), your FCF to EV ratio would have been… about 9x.

In other words, the price appreciation is strictly a result of the commodity price improvement, coupled with a very small multiple decline (which the truer computer models out there which algorithmically trade all these fossil fuel companies on a formulaic basis perform).

For the fossil fuel components in my portfolio, I have pretty much given up on any other smaller companies other than the big three (CNQ, CVE and SU) simply because I have little in the way of competitive advantage to determine which one of the smaller companies have better on-the-ground operations and superior geographies to work with. They all trade off of the commodity curve one way or another. The “big three” are low cost producers and will generate some amount of cash going forward, barring a Covid-style catastrophic environment.

They are basically the equivalent of income trusts at the moment. Remember the old Canadian Oil Sands (formerly TSX: COS.un) before it was absorbed into Suncor? That’s exactly that these three companies are – they all have gigantic reserves and very well established low-cost operations, and capital allocation that is simply going to dump cash out to dividends or share buybacks.

Risks inherent with all three:
1. A common regulatory/governmental risk being located in Canada, and mostly Albertan operations.
2. Fossil fuels may be subject to displacement if we actually see some sort of renaissance on nuclear power (there are whiffs of it here and there, but going from speculation to reality is another matter entirely).
3. The usual cyclical supply/demand factors.

With point #3, I see in the presentation decks of most of these companies (especially the smaller ones) that they are very intent on increasing production. Despite the fact that TMX is going to be operational in a month, the egress situation out of Canada will once again saturate. No more refineries are being built and thus the demand-supply variable will likely push WTI-WCS differentials higher at some point in the near future. With balance sheets of all the companies stronger than they ever have been, there will likely be some “race to the bottom” effect coming in due course, similar to how the domestic natural gas market has been saturated – both AECO and Henry Hub commodity pricing are quite low and LNG export pricing is back to its historical levels (around US$9.50/mmBtu spot).

I think what will happen is that the higher capitalization companies will use their relatively stronger balance sheets to pick away at the entrails of the smaller, higher leveraged operations when the price environment goes sour. Given the overall under-leveraged bent most of these smaller companies have been taking as of late, this process going to take awhile and a lower commodity price environment to achieve. These are not “forever hold” companies, but certainly at present their valuations continue to look cheap.

Melcor REIT – another cutting distributions to zero

Melcor REIT (TSX: MR.UN) is a small REIT containing 38 properties that is controlled by parent Melcor (TSX: MRD). The book value of assets are $700 million, debt about $420 million and about $12 million in cash flow from operations each in the past couple years. At 13 million units outstanding and at $3/unit, I will leave it up to you to calculate the market capitalization and relative size of this trust to others.

On March 5, 2024 they announced their year-end results. While the actual results were tepid, the big news was the trust finally reduced its distribution to zero citing financial flexibility.

Putting a long story short, they are hitting a debt wall as outlined by one of their significant holders, FC Capital in a letter that came public on March 13.

I won’t delve too deeply into this other than that we have a couple themes in action with this and Slate Office and other marginal REITs:

1. Debt maturities are killing equity value
2. The valuation of illiquid private equity (or in this case illiquid property holdings which is almost as bad) on balance sheets is highly suspicious when it comes to the time that you actually need to liquidate said properties.

You’ve got Allied (AP.UN), Dream Office (D.UN), Artis (AX.UN), H&R, etc, etc., all trading at wildly deep discounts to book value. The financial engineering solution is to liquidate the assets at their stated value and watch the magic happen, right? If it only were that simple!

Just wait until the CPP and other pensions that are heavy on “private” or otherwise illiquidly-valued assets finally get their day in the valuation sun.

In the meantime, the REITs appear to be a reasonable canary in the coal mine, begging central banks for supplemental oxygen.

Microstrategy cornering the Bitcoin market

A moment of market history was when the Hunt Brothers attempted to corner the market on silver (Silver Thursday), which occurred from 1979 to 1980.

If the article is accurate, the Hunt Brothers at one point controlled a third of the world’s privately available silver supplies, primarily using futures contracts.

The collapse of the scheme occurred when the highly leveraged Hunt Brothers could not post sufficient equity to keep their margin loan going.

Fast forward 44 years and we have the situation with Microstrategy and Bitcoin, which appears to be an analogous situation.

On March 11, 2024 via Form 8-K, Microstrategy announced they had purchased 12,000 Bitcoin, during the period between February 26, 2024 and March 10, 2024, for $822 million, mostly with the proceeds of an $800 million convertible debt offering (0.625% coupon, maturing March 15, 2030, convertible into equity at $1498/share). After this filing, Microstrategy owned 205,000 Bitcoins purchased at a cost of $6.91 billion.

I will note this date range of the purchased Bitcoin appears to line up exactly with the rise from $53,000 per Bitcoin to around the $67,000 we see today:

This wasn’t enough.

On March 15, 2024, Microstrategy closed another convertible bond offering, $525 million (0.875% coupon, maturing March 15, 2031, convertible into equity at $2327/share). Unlike the previous offering, this offering claimed to be used for general corporate purposes and the purchase of additional Bitcoins.

With the stock price (after a 15% drop as of the writing of this article) at about $1,500 a share, they are obviously continuing to leverage themselves to the hilt in order to keep the price of Bitcoin high. The liquidity of Bitcoin itself is somewhat questionable – throwing $820 million into Bitcoin over 10 trading days is enough to spike it around 30-40% in value. Microstrategy is clearly trying to keep as much gasoline onto the Bitcoin fire as it can, as its market valuation is tied to the hip with it. The primary owner and chairman, Michael Saylor, is dumping stock like crazy while the going is good.

My only question is when will this house of cards collapse?

The answer is strange – it depends on whether the stock collapses. It may not happen soon. The looming debt maturity was going to be in 2025 with a $650 million convertible note, but it is likely that it will be converted at approximately $398/share. The next looming debt maturity are the 2027 notes, which has a conversion price of $1432/share, which is much closer to the current stock price.

As long as the company can keep the stock price up and be able to avoid raising cash (presumably by selling Bitcoin!) in order to pay for the maturity, this can go indefinitely.

The cycle would be: issue equity or convertible debt financing -> purchase bitcoins -> raise the price of bitcoins -> higher MSTR stock valuation -> issue equity or convertible debt financing

The question will eventually be settled by somebody with deeper pockets than Microstrategy that decides to short enough Bitcoin and also Microstrategy stock to get an even larger payoff in the subsequent collapse. They would need to force Microstrategy to sell its Bitcoin.

Fairfax gets a short selling hit piece

Muddy Waters put out an interesting hit piece on Fairfax, accusing the corporation of using accounting tricks to overstate its true book value by about USD$4.5 billion. FFH’s stated equity in September 2023 was USD$21.6 billion. This accused mark-down isn’t gigantic, but considering that Fairfax is trading at a healthy valuation over book (about ~~1.5x~~ 1.2x) a valuation with a constant P/B multiple metric would result in an approximate 20% haircut all other things being equal. The stock is down about 10% today as I write this.

Skimming through the presentation, the bulk of the accusation is centered around the accounting of purchases of various subsidiaries and not taking or being able to cleverly avoid write-downs.

Fairfax is a massively complex entity and the stated financial position of various entities, whether in Fairfax or in other entities that try to do private market equity (or even real estate valuation for commercial REITs!) is ultimately up to a management judgement using some semi-standardized variables. The reality of these valuations are achieved when the entity involved tries to liquidate the venture in question.

The other accusation revolved around the application of IFRS 17 and the subsequent accounting adjustment in contrast to other insurance firms. Among other items, IFRS 17 applies a discounted value to the expected liability component of an insurance contract payout. Muddy Waters accuses Fairfax of being an outlier in relation to some other insurance firms. I have no good way of evaluating this other than that if a company anticipates its insurance payouts longer in the future, the stated liability reduction will be greater.

Finally, from the IPO to present, I did note that Farmer’s Edge was a disaster, including that of Fairfax, and its privatization offer is probably some attempt to internalize Fairfax’s upcoming loan loss on that venture. The amount, relative to the whole Fairfax consolidated entity, is small beans but blowing a high 8-digit figure of money is not chump change for most mortals like you and I!

I’ve looked at Fairfax here and there over the past couple decades and while there was a reasonable valuation case to be made when it was in the 400-500s, I found the stock to trade rich lately, even without the news of this particular short selling report. Ultimately the firm’s ability to dredge out cash flows from its insurance operations (which the metrics are quite excellent if they are to be believed!) is what is going to matter, not necessarily the stated book value of the various subsidiaries and minority investments on its balance sheet – if your assets are generating (this is a made-up number) $2 billion dollars cash a year, it doesn’t matter whether you keep them on your balance sheet at $20 billion or $30 billion – you’re getting $2 billion of cash – just that your return on assets metric will get skewed as a result.

Of course, if you compensate your management on the increase in book value per share instead of free cash flow, you will likely get a result where your management will pull out every derivative contract trick on the planet to artificially goose up the book value number. I suspect this may be the case if the report has any validity.

Either way, I have no position in Fairfax, and not too much interest either aside from watching this as a financial spectator.