Bombardier paper napkin valuation

Based on the slides on their investor day, looking at their 2020 financial roadmap, if the corporation is seriously able to reach $25 billion in revenues and 7-8% in EBIT, the quick calculation is the following:

$25 billion revenues
* 0.075 EBIT margin
= $1.875 billion EBIT
Less: $750 million interest expense (Assume $10 billion debt at 7.5%);
= $1.125 billion EBT
Less: $298 million (15% Federal + 11.5% QC = 26.5% taxes)
= $827 million net income

At this point they would likely have around 2.3 billion shares outstanding, so this would equate to about 36 cents a share. Just picking a P/E out of the cloud (15) and multiplying gives a $5.40 share estimate, or about 4.2x above existing market value, or about 33% CAGR if we use the full five years starting today.

Of course, for this to happen, a lot of execution risk (technical, marketing) has to be resolved, but management did a fairly good job solving the immediate financing risk – investors and customers no longer have to care whether the company is going belly-up or not (they are not).

I stress this is a total paper napkin exercise. Actual valuations under a more rigorous process can vary by a factor of 10!

Bombardier Bailout, part 2

Today’s big news is that Bombardier is selling 30% of its transportation division to the Quebec Pension Plan (CDPQ) for $1.5 billion.

The quick analysis is the following:

1. BBD will have received a cash injection of US$2.5 billion as a result of selling 49% of its C-Series aircraft interest and 30% of its transportation division; this will alleviate any short-term solvency concerns (from the September 30, 2015 balance sheet, they will have over CAD$5 billion liquidity to deal with). This capital is obtained with zero interest cost and some potential dilution of shareholders if the common share price ever gets above the US$1.66 exercise point (which one would hope it does in the recovery scenario!). Near-term bond yields (2018 maturities) are trading at 6.8%, while mid-range debt (2022 maturity range) is between 10-11%. The market is still skeptical of the financial recovery of the corporation.
2. BBD issues another 106 million warrants at an exercise price of US$1.66 on their subordinate voting shares. This is in addition to the 200 million they issued with the previously announce US$1 billion investment from the Quebec government.
3. BBD is required to maintain a cash balance of US$1.25 billion otherwise control on the board will start to erode.
4. This will save BBD from the hassle of doing an IPO (i.e. going through a regulatory quiet period, doing an institutional investor road-show, etc.), but noting that the CDPQ will have rights to trigger an IPO after 5 years of investment. CDPQ will also have significant minority shareholder rights.
5. If the Government of Canada wishes to tag along with some sort of contingent financing offer or backstop, BBD is in a considerably better position to negotiate as they will have sufficient financial reserves to do so.

I view this generally as a positive for the corporation, although they will still need to execute on getting the C-Series jet out the door and be able to generate sales. However, they seemed to have tackled the immediate perception issue of financial trouble, and have shown the financial world that the Quebec government will do whatever it takes to ensure Bombardier’s survival. If the Government of Canada chips in some cash, it will be icing on the cake.

My assessment of the preferred shares is still the same – they will likely pay dividends for the foreseeable future. At CAD$6/share, BBD.PR.B gives off a 11.25% yield, while BBD.PR.C is sitting at around 16%, with the risk that they’ll be force-converted to 12.5 shares of BBD.B – something I doubt management will do, but financially speaking it would make sense to issue 118 million shares to save CAD$14.7 million/year cash flow – with the way they are treating their equity holders, they might as well eliminate this headache off the books. This is the most likely reason why there is such a yield spread between the preferred share series.

Bombardier bailout

Bombardier reported their financial results on October 29, which were ugly as expected – they bled through about $315 million cash on the operating side and a gross $500 million on the investment side for the 3 month period.

This and the next quarter should be the the worst of it.

There are a few tail-winds now that will make an investment in their preferred shares likely to pay off beyond the receipt of dividend coupons.

I did not mention this in my July 29th post, a strong component of this investment is due to the political factor – the Government of Quebec, and now by extension by virtue of the Liberal Party’s recent victory nationally, the Government of Canada is not going to let Bombardier fail due to the political connections existing between the controlling shareholder and the government apparatus.

In other words, the company will not fail due to liquidity concerns alone – it may fail due to simply being unable to produce a jet, but it won’t be for financial reasons.

Bombardier took a billion dollars from the government of Quebec for a half equity interest in the liabilities of the new jet they are producing. They also issued 200 million warrants to purchase Class B shares at a strike price that is a premium of approximately 50% above the existing market rate – which would dilute shareholders in the event that things went well.

Examining the market reaction (which on net was rather mute), the BBD.PR.C issue, in particular, is trading at an increased yield, presumably due to conversion threat (they can be converted into BBD.B shares at the higher of 95% of market value or $2/share – and at current market prices, this means 12.5 Class B shares per preferred share).

The short end for Bombardier’s bond yield curve also came down – with their new term issue (March 2018) suddenly trading at par from about 94 cents a month earlier.

The new federal government is sworn in on November 4, 2015. It is virtually certain the new government will table an interim budget measure that will announce the easy to implement campaign platforms during the past election campaign – ratcheting down TFSA contribution limits, adjusting marginal tax rates for middle income earners, creating a new tax bracket for high income earners, etc. But one of the early decisions the new government will face is whether they wish to throw some money at Bombardier. I do not believe a federal investment is likely right now (just simply due to transition and the lack of immediate political necessity), but it remains a distinct possibility in the 2016 budget which will probably be tabled around February or March.

The Quebec investment is on the equity side – and preferred shareholders should benefit from this transaction.

I find it very difficult to believe at this juncture that Bombardier will suspend dividends on their preferred shares and they will muddle their way through what has been a financially disastrous investment in the C-Series jet.

The preferred shares continue to be a high risk, very high reward type investment if things proceed to fruition.

A short squeeze on Bombardier

Back on July 29th, I posted I had purchased preferred shares in Bombardier. I wish I had started my averaging a couple weeks later (did pick up a few on the dip), but nonetheless what I expected to happen has happened over the past week, especially over the past couple days.

The catalyst (or rather the assumed story to cause all the excitement) was that a “crown corporation” in China was interested in purchasing lump-sum the rail division for a huge amount of money (enough to pay off nearly all the debt the company had).

While this may be the cited story, the reality is that sentiment was horribly depressed in the marketplace for a company, while clearly having operational issues, that was punched well below what should be a fair valuation range. It took a catalyst event for the mindsets of the traders, investors and institutions to re-value the company in-line to something that was more reasonable.

There will likely be a few slip-ups in the preferred share pricing between now and over the next year, but anybody picking up preferred equity is likely to receive their stated cash flows for quite some time to come.

While in general I think the market is still not showing many investment opportunities (at least from my eye), this was a rare opportunity in a very well-known Canadian TSX 60 issuer in the large-cap space (or at least they were large cap before this all began!). I very rarely dip my toes into the large cap sector.

The bond yield curve has also taken a similar descent.

If my nominal scenario comes through you’ll see the preferred shares at around a 7.5-8.0% yield range in a year. This will be about $20 for the BBD.PR.C and $9 for the BBD.PR.B series (interest rates are still projected to be very low going forward), which represents another 50% capital appreciation or so for much less risk (albeit slightly less reward) than the common shares.

I remain long Bombardier preferred shares.

Purchased Bombardier Preferred Shares – Investment Analysis

Bombardier (TSX: BBD.B) has been on my radar screen since the beginning of the year when the pulled off a secondary offering that was force-fed to the public.

Over the past week I have bought Bombardier’s preferred shares. Specifically I have bought the preferred shares BBD.PR.B and BBD.PR.C, which have somewhat different characteristics.

BBD.PR.B gives out a dividend that is adjusted according to the prime rate given by the various big banks. Right now prime is 2.7% on a $25 par value, so that works out to 67.5 cents per share, paid out in monthly installments. At today’s market value it is trading at a yield of 11.1%. The shares can be converted to BBD.PR.D in August 2017 at a rate that is to be previously declared by management that is a function of the 5-year Government of Canada bond yield. In August 2012 it was 220% of the 5-year bond yield. Generally speaking with bond yields as they are at present I would not expect too much of a fixed premium to be assigned to the conversion.

BBD.PR.C gives out a 6.25% dividend on a par value of $25, so $1.5625/share paid in quarterly installments. At today’s closing price that works out to a 13.1% yield. This series of preferred share can be converted by the company into BBD.B equity at 95% of the closing price of the shares over a pre-determined time span or $2/share, whichever is more.

Both series of preferred shares are cumulative.

So why buy into something so obviously risky? The short story is that this appears to be a high risk / very high reward situation. There are a few reasons to believe that the risk is higher than what the market is perceiving.

On a technical basis, it is clearly obvious that investors have given up on the company. Anybody sitting on the preferred shares since the beginning of the year has lost about half their equity and the same can be said for the common shares. While this is a relatively unscientific comment, sentiment as seen through the stock graph is horrible. The sentiment could get even worse (i.e. go to zero) but despite what most retail financial literature specifies, portfolio returns are highly magnified if you can avoid catastrophic time periods and likely most of Bombardier’s catastrophic period is in the past. Price and volume suggest panic and it is best to invest in a panic situation.

I can’t see people within various pension funds and institutional investors credibly recommending to their investment committees the purchase of Bombardier at this time. The risk has simply gone too high. As a result, the shares (both common and preferred) have cratered. The question at this point is assessing whether sentiment can get worse (resulting in lower prices) or has bottomed.

Operationally and in terms of sentiment, the mass media has focused on the consistent delays on the C-series airplane that is designed to compete against others in the 100-149 person segment. The development of this aircraft continues to cost the company considerable amounts of cash – debt has risen to $9 billion at the end of March 2015 compared to $5.4 billion at the beginning of 2013.

In fairness, the cash balance between those two time periods has also gone up, from $2.6 billion in January 2013 to $4.7 billion in March 2015. The net debt position would be $4.3 billion which is not terrible.

In the last raising of capital, the company forced through a bond offering that functionally extended their nearest term maturity out to 2018. They managed to get a 5.5% coupon on 3.5 year money and 7.5% on 10 year money.

Investors that bought into the 10 year bond would doubtlessly be pleased to know that what they had bought at par is now 83 cents on the dollar (or approximately 11% yield to maturity). The 3.5 year maturity issue last traded at 94.7 cents (or 7.6% YTM).

Their yield curve would still suggest they are not going to be shut out of debt financing.

bbdyieldcurve

So they have a couple years to figure things out. Considering they have seemingly gone through a whole host of management changes in the first half of the year, presumably there will be a renewed focus to solve the issues the company is facing. I also do not know of any aircraft projects that were ever delivered on time and budget.

The company has a profitable transportation division which they are planning on bringing public. This would also give the underlying entity a bit more market value than what is being prescribed (a 3.8 billion market cap plus $4.3 billion net debt position gives an enterprise value of approximately $8.1 billion). For a company doing $20 billion a year in revenues, one would pause to think if a more rational valuation were prescribed to the firm on the basis of revenues.

It is likely any recovery in the company would clearly result in equity appreciation for the company, but also as the credit profile improves, preferred shareholders (especially the BBD.PR.B series) would see considerable capital appreciation, nearly in line with the common shares, with the added bonus of the income payments on the side.

If interest rates rise, BBD.PR.B investors would receive a small bonus. I’m not holding on my breath for an increase in interest rates, however. However, I do believe that 0.5% is the lowest the Bank of Canada will go.

There are obvious risks. The chief risk is the company will suspend dividends and the shares would most likely drop to half of what they are trading at presently. The company suspended dividends on common shares earlier this year and may decide to drop preferred share dividends as they constitute a cash drain of CAD$23 million/year that they would want to otherwise save. They can also save half of this by converting the BBD.PR.C series into equity, a decision that I doubt they would make (they would rather suspend the dividend instead).

There are two good reasons why they won’t: they would likely compromise their ability to access the bond market, and the controlling family (that owns a majority of the votes in the corporation) would lose one more element of the privilege of controlling who is on the board of directors: declaring common share dividends. It does not seem likely at this time that they will suspend dividends unless if things get worse than present. There are other issues concerning the control issue that I will not write about in this post.

There are other positive and negative catalysts, most of which are not being priced into the market. I won’t go into those.

I have omitted a lot of the analysis (including the relationship between the various world governments and Bombardier), but I have written several elements to consider. While I am not too interested in the common shares, the preferred shares do give me interest, thus my purchase. This is not for the faint of heart – this is a high risk investment. If a stabilization comes to fruition and Bombardier manages to plod along, the preferred shareholders are good and will be earning significant income for the indefinite future.