Home Capital Group, Equitable Group

Home Capital (TSX: HCG) and Equitable (TSX: EQB) have been hammered today as a result of fallout of the Ontario Securities Commission allegations that certain Home Capital Group executives have contravened the various regulations. They continue to perform damage control, today announcing their CFO (who was under the OSC investigation) will be stepping down and other various board changes.

Borrowing rates for Home Capital spiked to 26% today. Equitable, which normally has been an inexpensive borrow, had its cost to borrow rise to 2.75%.

Implied volatilities on options for HCG is also very expensive at present, around 110% for near-dated options and around 90% for a couple months out. EQB does not have options trading on their shares.

There has been an avalanche of media coverage (both in print and social media) about Home Capital and their woes. They have been pushed down to about 25% less than tangible book value.

This spill-over has not occurred to Genworth MI (TSX: MIC) at present.

The closing sale for Davis and Henderson

I’ve written a little bit about D+H Corporation (TSX: DH) in the past. On March 13, 2017 they received an all-cash buyout offer for CAD$25.50 from an international firm and there is no reason to believe this will fail.

In my opinion, DH shareholders are getting a good deal since there are plenty of storm clouds on the horizon for the company.

However, there is a lesson for me in this story even though the last time I owned shares was in 2010.

Back in October 2016 when they released their disaster of a quarterly earnings report, their stock subsequently traded as low as CAD$14.06, although realistically if you had started accumulating after their earnings disaster you would have received an average price of around CAD$15/share. I also predicted the company would slash its dividend in half (which it nearly did, from 32 cents to 12 cents a quarter) and thought the stock would get hit even further as I projected a spiral of selling by panicked investors.

This did not happen. Instead, when they announced their dividend slashing, the stock quickly went up to $16 and never looked back. The company announced a strategic review to sell out the firm on December 7, 2016 which sent the stock up to $21/share and you can see the rest of the story in the stock graph.

So in the span of six months between an earnings disaster and the buyout offer, the company’s stock price has appreciated by a factor of 70%.

In retrospect, the October quarterly report and subsequent dive in stock price (from $28.70 to $16.20) should have been an equity purchasing event, not an event to continue throwing eggs and rotten tomatoes at the corporate body.

It makes me wonder about my valuation methods and why I got this one incorrect.

I wasn’t in a very good position to invest back in October 2016 (I was mildly leveraged at the time), but even if I was in more of a cash situation I probably wouldn’t have dipped my toes until around CAD$12/share where I would have seen an acceptable risk/reward ratio.

I have performed equity and debt research on hundreds of companies. Some companies I keep current on even though I have not taken a position on them. Some companies I just look at once and don’t look at them again until years later when there is some reason for them to show up on my radar again. There are also some like D+H that I have invested in a long time ago and check in from time to time. Whenever companies like these appear again, there is always the knowledge that I have done my due diligence over a larger period of the company’s history compared to those that are freshly looking at the company. In the case of D+H, it will be sad to see this accumulated research knowledge go away, but that is life as an investor in publicly traded securities.

KCG Holdings: Bought out

KCG Holdings (NYSE: KCG) looks like it will finally be bought out by Virtu (Nasdaq: VIRT) for US$20/share, cash. They also announced their first quarter results, and according to my scorecard they did better than expected – while their bottom-line net income was slightly negative, they were significantly better on trading revenues than I was expecting. I was expecting a very lacklustre quarter due to incredibly low market volatility in the quarter. Interactive Brokers (Nasdaq: IBKR) is a regular conference call I read and they can attest to the impact of low market volatility on trading.

My investment history with KCG is quite fascinating. I did not disclose things here until October 2016, but I have been trading the stock at various times since 2013, which resulted in material performance gains, especially in 2013 (I took a fairly heavy call option position at the second half of the year). It has exhibited a narrow price range since its merger with GetCo after their August 2012 trading blow-up. The company has generally been off the radar of most investors as it received little analyst coverage and was treated like toxic trash.

Virtu has a plan to raise $1.65 billion in debt financing for the merger and also has sold $750 million in equity at $15.60/share, which should make the buyers happy considering they are now trading at $16.40/share – the market believes this will be quite valuable for Virtu. KCG’s existing 25% shareholder has consented to the agreement, which makes it very unlikely that the deal will not pass through KCG shareholder approval. Given the highly strategic nature of the acquisition, I also doubt there will be other competitors for KCG. Thus, this merger looks like a done deal.

Current trading is at US$19.75. The expected closing is in the third quarter of 2017. As the current spread between market and US$20.00 is around 127 basis points, this would imply a merger arbitrage spread of about 3.8% annualized, so I am in no rush to sell as I have nothing else to deploy my capital into.

The only other issue of concern is KCG’s senior secured debt, maturing on March 15, 2020. According to the fine print, the notes can presently be called off at 103.438 cents on the dollar and there is a required offer for 101 cents on the dollar due to the change of control (which would be redundant since the notes are trading over this in the marketplace). I would suspect Virtu would be eager to get these notes off the books as quickly as possible as they contain covenants that would otherwise restrict the KCG entity. I’ll hold onto these as long as possible but do not think they will survive much longer.

April options on KCG Holdings

The April options cycle expires on Friday, April 21. Not including today, this leaves 3 days of trading before expiry.

KCG Holdings (NYSE: KCG) is hovering around US$17.50 and their April 18 call options have a substantial bid of 16 cents, which puts them at an implied volatility of about 48%. Their historical volatility has been much less than this (typical options have been trading at around 20-25%, depending).

This is somewhat unusual, and probably instigated by the previous unsolicited buyout proposal at US$18-20/share prompted by Virtu (Nasdaq: VIRT) last month. Will there be a more solid proposal that will be made public soon?

Canadian Housing Finance stocks, April 13

On April 13, three notable companies associated with Canadian housing pricing fell considerably: HCG, EQB and MIC.

There were a bunch of other companies that had issues, but it looks like that the trio above were fairly pronounced in the day’s list of losers:

April 13, 2017 TSX Percentage Losers

CompanySymbolVolumeClose% Change
Nthn Dynasty Minerals LtdNDM4,841,0272.17-10.3
Intl Road Dynamics IncIRD203,2032.81-10.2
China Gold Intl Res CorpCGG1,269,5942.43-9.3
Home Capital Group IncHCG972,60621.70-8.6
Aphria IncAPH6,005,7937.21-8.3
Equitable Group IncEQB287,51263.41-8.3
Fennec Phrmctcls IncFRX12,5375.50-8.0
Silvercorp Metals IncSVM1,516,9934.94-8.0
Alacer Gold CorpASR1,881,2092.52-7.7
Street Capital Group IncSCB28,4891.40-6.7
Taseko Mines LtdTKO794,6751.52-6.2
Trilogy Energy CorpTET182,4814.95-6.1
Genworth MI Canada IncMIC221,17434.63-6.0
Top 10 Split TrustTXT.UN9,8634.08-6.0
Guyana Goldfields IncGUY916,0127.41-5.4
Golden Star Resources LtdGSC548,2681.09-5.2
Continental Gold IncCNL852,8253.91-5.1
Arizona Mining IncAZ501,4501.96-4.9
Great Panther Silver LtdGPR387,1652.00-4.8
Argonaut Gold IncAR1,036,6442.43-4.7

I’ve been trying to find what caused this spontaneous meltdown in equity prices.

My 2nd best explanation is that Bank of Canada Governor Stephen Poloz is putting a torpedo to the Toronto housing market by making explicit statements about the 30% year-to-year rise in valuations and about how there is no explanation for it. Specifically, he stated “There’s no fundamental story that we could tell to justify that kind of inflation rate in housing prices, and so it’s that gap between what fundamentals could manage to explain and what’s actually happening which suggests that there is a growing role for speculation“, which is a mild way of saying that people are basically trading houses in Toronto like they did with Tulip Bulbs in the Netherlands in 1636.

He also politely stated that if you believe that housing prices are going up 20% year-to-year, it doesn’t matter whether he raises interest rates by a quarter or half point, and he could even raise them 5% and it wouldn’t make a difference (although it would be rather fun to see him try and see all the mathematical financial models predicated on stability go out the window in one massive flash crash).

However, my primary reason why I think the three stocks crashed is a simple announcement:

==========================

Media Advisory
From Department of Finance Canada

April 13, 2017
Minister of Finance Bill Morneau will hold a meeting with Ontario Finance Minister Charles Sousa and Toronto Mayor John Tory to discuss the housing market in the Greater Toronto Area.

A media availability will follow the meeting at approximately 3:30 p.m.

Date and Time
2:30 p.m. (local time)
Tuesday, April 18

Location
Artscape Wychwood Barns
601 Christie Street
Toronto, Ontario

==========================

Being somewhat experienced with the nature of government communications, there is no way you can get a federal and provincial Liberal with a Conservative mayor doing a joint announcement on something without it leaking to the marketplace.

The only question here is how deep they’re going to stick their silver-tipped oak stake into the heart of the Toronto real estate vampire.

Home Capital Group – The cliche about smoke and fire applies

Home Capital Group (TSX: HCG) fired its CEO today.

The manner that it did suggests that there was a considerable disconnection between the information the Board of Directors was receiving and what management actually knew about the situation (or over-boasted about its damage-control abilities).

My guess is that the final straw was the dealings concerning the Ontario Securities Commission alluded to in the March 14th press release.

Home Capital Group is notorious in my mind for having a very high cost to borrow shares for shorting – it is the biggest proxy used by most people to bet against the fortunes of the Canadian real estate market – right now it would cost you about 22% to borrow to short. Those short sellers will probably be most happy to cover some of their holdings tomorrow (or depending on their risk horizon, add to their shorts!).

Pengrowth executes an asset sale

Pengrowth Energy (TSX: PGF) managed to execute an asset sale on its conventional production property north of Edmonton, the Swan Hills assets for CAD$180 million.

The debt profile at December 31, 2016 looked like this:

Right now the CAD/USD ratio is 0.75.

At the end of December 31, 2016 they also had CAD$287 million cash in the bank, plus another CAD$250 million for the 4% gross royalty sale on their Lindbergh asset.

They will be redeeming CAD$126.5 million in convertible debentures on March 31, 2017. They also have redeemed US$300 million of their 2017 debt maturity, and will redeem the rest after this transaction concludes at the end of May.

The company announced that after this sale, they have a pro-forma net debt of CAD$970 million.

My math suggests that after the 2017 redemption, they would have CAD$57 million cash left, assuming their operations consume zero cash (not a correct assumption!).

Payment of the debt will result in an interest expense decrease of $42 million per year.

They still need to have CAD$368 million on-hand on August 2018 in order to pay off their next debt maturity. It is possible they will run into covenant issues given that oil hasn’t moved around the US$50/barrel mark – their existing senior debt to adjusted EBITDA ratio would be the most material of it. They have about CAD$1.02 billion outstanding and their EBITDA needs to be above CAD$290 million in order to clear this hurdle.

Although the EBITDA value for covenant purposes was CAD$582 million, this is a skewed figure due to the employment of hedging. People not versed in accounting procedures for commodity hedging will have a tough time figuring out the mess, but I will just point out that management closed out their hedges in 2016 (which had been a VERY profitable transaction to them that otherwise would have guaranteed CCAA had they not had the foresight to doing so when times were much better).

KCG Holdings – Takeover bid from Virtu

The Q1-2017 report is going to be shockingly positive. Genworth MI (TSX: MIC) used to be my largest holding, but I have trimmed the position (mainly for diversification and deleveraging reasons). It still is a decent size of the portfolio, but not as prominent as it used to be.

My largest position after Genworth MI was KCG Holdings (NYSE: KCG).

Yesterday, near the close of trading, they confirmed that they received an unsolicited takeover proposal of US$18.50-20.00 per share from Virtu (Nasdaq: VIRT), another (very credible) high frequency trading firm. KCG did not file with the SEC.

Virtu filed 8-K with the SEC confirming they “made a preliminary, non-binding proposal to acquire KCG”.

Both entities have been quite silent otherwise. There is likely a lot of backroom jockeying going on.

KCG’s stock shot up from about $13.60 a share to $18/share today on over 6 million shares of volume. The company has about 66.4 million shares outstanding, and Jefferies (a wholly owned subsidiary of Leucadia (NYSE: LUK)) owns 15.41 million shares, and insiders own another 3 million shares, leaving a float of about 48 million shares that can be actively traded. 6.65 million shares traded today and suffice to say there is quite a large amount of speculation about what is going to happen.

My take on the matter is the following (in no particular order):

1. Tangible book value of KCG Holdings is $18.71/share as reported in their 10-K filing. A US$18.50 takeover price would allow Virtu to effectively take over KCG for free. This is the primary reason why I wouldn’t think this takeover would go anywhere as-is. My guess is that if Virtu was serious they would have to offer some equity as well, or some sort of premium to book value.

2. Virtu is a logical strategic acquirer to KCG – the synergies are quite obvious to both businesses. There might even be anti-trust issues with this acquisition.

3. Even though the acquisition at the low price range would be “free” for Virtu, it leaves the question of how they would immediately finance it.

4. The Jefferies control block is vital to the situation – if they can be persuaded to sell out, then management will likely have to follow. The question is whether they are motivated to sell out or not – obviously they will at the right price, but US$18.50 is too low.

5. The CEO was granted a huge amount of options at $22.50/share (priced well out-of-the-money at the time of the grant) and probably doesn’t have much of an incentive at this point to selling out the company for cheap.

6. Operationally, KCG is treading water in terms of cash flow, but this is because of unprecedented low market volatility conditions that is practically the worst environment for the firm (and also Virtu). In more normal conditions, one could easily estimate a value of US$25-30/share for the firm which is where I think management is targetting. They’ll probably sell out at 24ish if the bid got there.

7. Who leaked this unsolicited offer? Obviously KCG did – probably trying to drum up any counter-proposals out there as there are some other financial institutions that would be interested in acquiring the business. Perhaps management knows the end-game is nearing and this was a last ditch attempt to prevent a forced merger.

The decision forward is a high-stakes game for a lot of participants!

Disclosure: I own common shares of KCG, call options, and also their senior secured debt. Sometimes you really do hit the lottery in the marketplace.

Difference Capital – Year-End 2016 Report

I wrote about Difference Capital (TSX: DCF) in an earlier post. They reported their 4th quarter results a couple days ago and their financial calculus does not change too much. They have CAD$29.6 million in debentures outstanding, maturing on July 31, 2018. Management and directors own slightly under half the equity, and thus they want to find a dilution-free way to get rid of the debt.

At the end of 2016 they have about CAD$14.4 million in the bank, plus $60.8 million (fair value estimate of management) in investments. One would think that in 2017 and the first half of 2018 some of these investments could be liquidated to cover the debentures. The situation is similar to the previous quarter, except for the fact that they’ve retired about 10% of their debt in the quarter, which is a positive sign.

Due to their investment portfolio not making any money (they have been quite terrible in this respect), they have a considerable tax shield: $186.3 million in realized capital losses, plus $41.9 million in non-capital losses which start to expire in 2026 and beyond. If you assume that they can realize both of these at half of the regular tax rates (I just quickly assumed 13% for the capital losses and 26% for the net operating losses), that’s $17.6 million.

Considering the market cap of the corporation is $26 million, there’s a lot of pessimism baked in. Mind you, there are a lot of corporations out there with less than stellar assets, a ton of tax losses, and tight control over the corporation (TSX: AAB, PNP quickly come to mind) so it is not like these entities are rare commodities. The question minority shareholders have to ask is whether the control group wants to bleed the company through salaries, bonuses and options or whether they are actually genuinely interested in profitably building the corporation (in all three cases, to date, has not been done).