A Yellow Media oddity

Yellow Media (TSX: YLO) has all sorts of securities where investors can lose their money, but some securities are more stranger than others.

In particular, there is a prevalent oddity I have been noticing in trading of preferred shares of Yellow Media. These are the Series 3 (YLO.PR.C) and Series 5 (TSX: YLO.PR.D) series of preferred shares, which essentially are identical in all respects except for their stated dividend payout.

I will refer to Series 3 as being the “C” series and Series 5 as being the “D” series. The C series pays out $1.6875/share/year while the D series pays out $1.725/share/year. Both contain a rate reset feature, where after 5 years from initial issuance, the C series will be reset to the 5-year government bond rate plus 4.17%, while the D series will be at the 5-year government bond rate plus 4.26%. The 5-year bond is currently yielding 1.57%, but the C series will have their reset in 2014 and the D series will be in 2015.

There are also 8.1 million “C” shares outstanding, while the “D” series has 4.9 million outstanding. There is more trading volume for the C series than the D series.

Taking the midpoint of the closing bid-ask quotation, the C series is trading at $4.24 and the D series is trading at $5.15. Using some very elementary math, this translates into a yield of 39.8% and 33.5%, respectively. Obviously these very high yields are a function of the embedded risk within the underlying company’s ability to actually pay such dividends – the huge issues the business has been facing has been well publicized.

You can arbitrage the difference between the C and D series by going long 102.22 shares of C, while going short 100 shares of D. Using the quotations above, such a transaction would be income neutral and net a capital gain of approximately $81.59 per 100 shares traded.

Practically this is not possible unless if you can locate cheap shares to borrow, but investors looking at both classes of shares should clearly choose the “C” series.

Other than supply-demand dislocations because of the different number of shares outstanding of both series, I am at a loss to figure out why there is such a huge yield differential between the preferred shares. One would think the more liquid series (C) would trade at a slight premium due to liquidity. Does anybody else know?

As a disclosure, I own some of the preferred shares of Yellow Media.

Credit coming to a crunch

It is quite evident looking at bond trading that credit is coming to a halt, very quickly.

First of all, I notice debentures on various firms are plummeting – most of the underlying companies have lots of refinancings ahead in order to make it through. An example of this is Data Group (TSX: DGI.UN), which has had its debentures trade down to 60 cents on the dollar.

Sterling Shoes (TSX: SSI) announced they will not be making their interest payments on their debentures, effectively putting them in default – their interest payment is due on October 31, 2011 and will subsequently lead to a potential default sometime in November according to their prospectus (if enough debenture holders are able to declare a default).

Superior Plus (TSX: SPB) was lucky to get off a $75M debenture financing (with a 5-year term at 7.5%) in the middle of September before their common shares started to fall off a cliff – and took the debentures (series C, D, E, F) with them. Superior Plus is no stranger to this website, having predicted a dividend cut in the past.

Yellow Media is no stranger to this site either, but since I am still licking my wounds on this one, I will leave it at that with this company. Similar to Superior Plus, however, both companies are still free cash flow positive.

First Uranium (TSX: FIU) has had some serious issues regarding their operations and financing, and also some political risk thrown into the mix. As a result, its secured notes have traded down. Indeed, when looking at the management projections for the July to September quarter, management has projected they will be left with about $9 million cash on their balance sheet before they can make a (what they think) turnaround – instead, they just might be ready to default since they also have a CAD$150M debt payment on their unsecured debentures due June 2012. First Uranium is also no stranger to our site, having had the misfortune of investing in their notes and debentures in the past.

Finally, Connacher Oil and Gas (TSX: CLL) has had their common shares annihilated over the past couple months – their unsecured debentures are due on June 30, 2012 and are now trading at 85 cents on the dollar. This is quite interesting in light of the fact that the rest of the company’s debt is structured out until 2018 and they have set up a credit facility to be able to pay off these debentures. The risk is that the company will simply convert the debentures into equity and you end up with another Arctic Glacier (TSX: AG.UN) which underwent a lot of dysfunction after they did the same thing with a very low stock price. Those debenture holders would have been lucky to realize half the value of their debt, or if you timed it perfectly and had a small amount of debt to work with, about two-thirds.

A lot of credit-sensitive companies are trading lower. It is difficult to tell when it will end, but an investor picking up the scraps of companies that will, through organic business performance, be able to bounce back will be very rich – similar to how anybody investing in the corporate debt market in early 2009 made out very well.

Timing indeed is everything.

Yellow Media restated credit facility – can they survive?

As Yellow Media’s shares (preferred and common) continue their descent to zero, they did release what was in their restated credit facility (attachment).

Notably are the following:

1. Article 8 covenants are fairly obvious – the company must report annual and quarterly statements in compliance with GAAP, etc. There is a reference to budgets and projections (8.1 (c) and (d)) that will likely mean that the creditors will have material information that the public does not have. Probably the same people dumping the preferred shares well in advance of this calamity!

[8.1 (d)] (x) a breakdown of print and online revenues, (y) distributable cash flow and distribution calculations and (z) expected revenue drivers and which projections should be in a format consistent with the September, 2011 Projections.

Also 8.10 requires the company to include more guarantors to the creditor agreement which are subsidaries of the company.

2. Article 9 covenants are more restrictive. They prohibit the taking out of further debt unless if under the credit agreement, except for minor items including capital lease obligations no greater than $25M, and also other minor conditions including intra-company debt;

9.3 prevents the company from acquiring or liquidating companies without being able to satisfy the existing covenants on a pro forma basis;

9.4 requires the company to remit any proceeds above $25M in a sale to the creditors necessary to achieve compliance with covenants on a pro-forma basis;

9.5 is the salient clause – it prohibits distributions to common shareholders (except for the last 2.5 cent common dividend upcoming), but includes the following clause:

(iv) the Borrower may declare and pay dividends on the preferred shares of the Borrower existing as at the date hereof,

This would suggest, as long as the company can make its other covenants that the preferred shares will continue paying dividends.

The important covenants, the performance-related ones, are the following:

9.7 Consolidated Total Debt to Consolidated EBITDA Ratio
The Borrower will not permit the Consolidated Total Debt to Consolidated
EBITDA Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be greater than the ratio of 3.50 to 1.

9.8 Consolidated EBITDA to Consolidated Interest Expense Ratio
The Borrower will not permit the Consolidated EBITDA to Consolidated Interest
Expense Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be less than the ratio of 3.5 to 1.

9.7 is a stronger covenant than 9.8; using the first half of 2011 results as a measure of these two, the company’s ratios would be as follows:

9.7: EBITDA (12-month extrapolated, realizing this is a flawed extrapolation) $366.5M*2 = $733M, debt at June 30, 2011 is $2.39B, for a ratio of 3.26:1. There was a large amount of debt paydown for the Trader Corporation sale, but the larger risk is the EBITDA number.

9.8: EBITDA: $366.5M for the first half; $84.6M in financial charges for the first half, for a ratio of 4.33:1; the financial charges going forward will be less due to the repayment of MTN’s, but the obvious risk here is the decreasing EBITDA;

The raw math boils down to the following: Can YLO keep its head above the EBITDA water? With the Trader Corporation sale, the company will have about $1.7B in debt to worry about, which means that its ultimate concern is being able to generate about $480M in EBITDA on an annual basis (or less if it continues to pay down debt). At present when you extrapolate the trajectory that its EBITDA is declining (2009: $903M, 2010: $860M, 2011: $366.5M in the first half), can they level it off at about 40% less than its 2009-2010 run rate?

If so, the company can survive its credit facility. If not, there will be a default.

High risk, high reward.

The optimistic scenario is if they can stem the decay and be able to survive its credit facility – I would guess that the preferred shares in such a case would trade around $17-18 if there is clear evidence that this is happening. Obviously we do not see any of that evidence currently and the next quarterly report is just as likely to be brutal.

Students of history will also remember that when Nortel was going through its preliminary death throes in 2002, they were contemplating restructuring and their preferred shares went down to about $1-2 before finally coming back up again. I remember that quite distinctly although I never purchased into Nortel preferreds back then. The analogy is not appropriate to this case (different business, different situation) but what is salient is that low prices give high risk, high reward type situations – there are many scenarios where it is likely that the preferreds of YLO will go to zero, but there are plausible cases where they will rise again.

This is why you never ever put significant fractions of your portfolio into picks that are high risk like this one – keep the bets tiny. At this point it’s really tough to distinguish between investing and gambling. Just as a point of reference, if you put 2% of your portfolio into a play like this and it goes up 10-fold (which the low-probability winning scenario is for the preferred shares if the company actually manages to get its act together), that 2% position will be a 20% position at the end of the day if you do not rebalance.

Just remember the likely scenario is that the 2% goes to zero!

Got my hands bloodied up catching Yellow Media

As I alluded to in an earlier post, catching plunging knives (in this case, catching plunging share prices) will leave your hands bloodied, and indeed this has been the case with Yellow Media.

They announced this morning that they will be suspending their common share dividend and also will be reducing the size of their credit facility to $500M, of which $250M will be paid off at $25M/year from the beginning of 2012 onwards.

This caused their common stock to plummet, but oddly enough, caused their preferred shares to drop equivalently, to the tune of 50%.

PR.C shares are down to $3/share, while PR.D shares are down to $3.08/share.

By slashing the common dividend, they will save about $77M/year in cash flow.

With the common share dividend gone, it will remain an interesting decision whether the company will decide to cut preferred share dividends. PR.A will cost the company $10.7M/year, but this will be alleviated when they convert them to shares in April 2012. PR.B will cost $7.6M/year, but this will also be alleviated when the company force converts them in July 2012.

PR.C is the next drain on cashflow – $13.2M/year, and PR.D is $8.5M/year. Both of these series are cumulative and can only be called by the company at par ($25) which is obviously not going to be happening with them trading at $3 over the open market.

The debentures are trading at 32 cents and represents a $13M/year interest expense for the company – these interest payments must be maintained otherwise it will constitute a default – a 20% current yield, but how long will you see those coupon payments being paid?

The real question is: how quickly is the company’s cash flow diminishing? This “decay rate” is the critical variable in determining how financially viable the company is going forward.

The company’s preferred shares are obviously a very high risk and high reward type situation if your assumption is that they are not going bankrupt and they will be able to level off their cash flows at a positive amount.

Bloody hands catching the Yellow Media falling knife

With the recent plunge of all securities of Yellow Media (TSX: YLO) I have decided to get my feet wet in purchasing a small mixture of the C, D preferreds and some convertible debentures.

Suffice to say, this is not a low risk investment. These securities are trading as if very, very, very bad things are going to be happening to the company, if not outright bankruptcy. The winning condition for an investor at these prices is that the company does not declare bankruptcy in the medium term future.

The business story is quite well known. The company is in the throes of a massive reorganization from print to digital and this has created tremendous risk.

The solvency of the company will be tested around the 2013 timeframe, when they face maturities of some of their Medium Term Notes and their credit facility. The upcoming maturities of the Medium Term Notes between 2013 and 2016 are the following (noting the values are as of December 31, 2010 – the company has repurchased some of these notes):

– $130 million of 6.50% Series 9 Notes maturing on July 10, 2013 priced at par, for an initial yield to the noteholders of 6.50% compounded semi-annually
– $125 million of 6.85% Series 8 Notes maturing on December 3, 2013 priced at par, for an initial yield to the noteholders of 6.85% compounded semi-annually
– $297.5 million of 5.71% Series 2 Notes maturing on April 21, 2014 priced at $99.985, for an initial yield to the noteholders of 5.71% compounded semi-annually
– $260 million of 7.3% Series 7 Notes maturing on February 2, 2015 priced at par, for an initial yield to the noteholders of 7.3% compounded semi-annually
– $387.4 million of 5.25% Series 4 Notes maturing on February 15, 2016 priced at $99.571, for an initial yield to the noteholders of 5.31% compounded semi-annually

Yellow Media Inc. has in place a senior unsecured credit facility consisting of:
– a $750 million revolving tranche maturing in February 18, 2013; and
– a $250 million non-revolving tranche maturing in February 18, 2013.

Notably, the credit facility has a covenant of a minimum ratio of Latest Twelve Month EBITDA before conversion and rebranding costs to cash interest expense on total debt of 3.5 times. Obviously if the financial performance of the company continues to dwindle they will be compelled to pay this off before the MTN’s. They have $636M outstanding on June 30, 2011 in these facilities.

The difference in capital structure between the preferred series and the convertible debentures is relatively minor – the debentures are $200M of face value (maturing October 2017) which have priority over the preferred shares. The higher price paid for the seniority is reflected in the fact that an investor is likely to continue receiving coupon payments (until if/when the company defaults on its more senior debt).

Finally, with the sale of Trader Corporation and the net proceeds of approximately $700M, the company will have further financial flexibility to maneuver around its credit facility covenants and be in a position to use its cash to repurchase debt. At current prices, such repurchases will be highly yielding – for example, if the company did a dutch auction tender for its convertible debentures at 40 cents a piece, every million dollars tendered would save the company from $162,500 of pre-tax interest payments.

The other trading note is that the PR.C series of shares has a slightly lower coupon than the PR.D series (6.75% vs. 6.9%), but the PR.D has typically traded at or lower than PR.C prices. There may be a liquidity premium as there are more PR.C shares outstanding. In addition, spreads are quite high until the computer algorithms put in very small bid and asks and since other algorithms are hammering the bid this tends to create quite a bit of price gapping. The last trading note is that every fund manager on the planet will be embarrassed to show these securities in their quarterly statements, so the “window dressing effect” will likely mean that they will be jettisoning their securities before the September 30th date (3 days for trade settlement means they will be getting rid of them by early next week). Since there is a lack of liquidity in the preferred series, this has resulted in dramatic price drops.

I anticipate the common shareholders are not going to be too happy when their dividend will get severely cut again and diluted by the preferred share conversions. However, the company will have to take these drastic steps to save itself and to de-leverage. Deleveraging is always a very, very painful process when it is forced.

I highly suspect that an opportune time to catch the falling knife is very close. Stocks are most volatile at their highest and lowest points and this appears to be a low frenzy. Time to get my hands bloody.

Yellow Media

Yellow Media (TSX: YLO) is an interesting case on how to value a company in an industry clearly in collapse (in this case, collecting advertising dollars by selling paper bricks known as phone books). They are trying to desperately diversify into the 21st century, but just like how newspapers have felt it very difficult to doing so with the same financial models in place, Yellow Media is also in an equivalent state. Although the company currently is cash flow positive, it is diminishing – the exercise in valuation is the future assumption of how rapidly this is diminishing and also whether there will be any flattening of the decay.

That said, the top-line operating cash flow number for the first half of 2011 was $199.6M vs. $293.5M in 2010; still a healthy amount of cash coming into the coffers. Common and preferred share dividends (at the annualized rate as of this writing) is about $118M ($59M for the half-year period at the newly reduced dividend rate), so there is currently room to accumulate cash and reduce leverage.

The company is quite heavily leveraged. As of June 30, 2011, senior to everything are the Medium Term Notes (with a varying series of staggered maturities) – $1,644M; and a $636M credit facility. Junior to this are the convertible debentures (TSX: YLO.DB), a $200M issue. The annualized interest bite on these securities is about $129M a year.

There are also four publicly traded series of preferred shares outstanding. Series 1 and 2 (YLO.PR.A and YLO.PR.B) have approximately 16.9M shares outstanding; these are convertible into YLO common at various dates at $2/share (or 95% of market value if YLO equity ever goes above $2.11/share). The principal value of these shares is $422M. The other series of preferred shares are perpetual with only a call feature (YLO.PR.C and YLO.PR.D) – both of these series give out a dividend and there are 13.6M shares outstanding, face value of $339M.

Yellow also sold Trader Corporation for a net $708M, which closed after the June quarter-end. During the release of this quarter, the company announced it was slashing its dividend from $0.65/share to $0.15/share and also stopping its share buyback so it can concentrate on repurchasing debt and preferred shares. At the end of August they have repurchased approximately $238M in Medium Term Notes, and some preferred shares.

A brief look at the valuation of the various securities – currently, the common shares are trading at 68 cents (giving the company a market cap of $348M, 511M shares outstanding). One item that is clear is that the common dividend is likely to not be sustained at the existing level – the $77M in after-tax cash flow out the window is going to be required to assist in the de-leveraging effort. Once dilution of the convertible preferred shares are factored in, another 210M shares will be added to the share count.

The convertible preferred shares are trading primarily as a function of the common shares (due to the fact that the company will likely convert the preferred shares into common shares as early as possible, especially as they cut the common dividend). This will save the company about $19M/year in after-tax cash flow. The perpetual preferred shares are trading roughly at 28 cents on the dollar (about $7 per share) and this translates into yields of over 20% – the risk is that the company will suspend dividends once they suspend the common share dividends. The market is obviously predicting that this will happen. If they do, they will save $22.4M/year in after-tax cash flow.

The next item on the seniority chain are the convertible debentures, which are currently trading at 41 cents. These convertibles mature in October 2017 (6 years to maturity), and have a 6.5% coupon, giving the debt a 15.9% current yield. Yellow cannot defer the interest payments or it will face default, so it is likely as long as the company has cash flow they will be able to pay interest on the debt.

The question for an investor is whether the company will be able to shore up its cash flow situation, and if so, whether it will be able to sustain indefinitely payments on its preferred shares or debt.