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.

Canadian preferred shares education

James Hymas has published a considerable volume of information concerning fixed-reset preferred shares. It makes for very heavy reading (i.e. this is not something you can casually read at a Starbucks), but if you are in the right frame of mind, there is a ton of educational content that you would never see in your typical MBA program.

He also has an equivalent document for a class of preferred shares that stand a better chance of being redeemed early due to regulatory capital requirements rules which I will not repeat here.

While I’m on the topic of James Hymas, he is very concise with his analysis on the Canadian real estate market, mainly that it is caused by “low interest rates”, “an explosion of CMHC guarantees”, and “unsatisfactory stock market returns”. Capital has to go somewhere and if you can’t get a 4% return from the stock market, you can at least go for a cap rate for the same in the real estate market. I will observe that 5-year bond yields have slipped to the 1.00% level again and 5-year fixed rate mortgage are available for 2.39% on insured mortgages. Why bother to put up any equity when money is virtually being given to you at the rate of inflation?

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.

Toys R Us – Not for me

Most people are familiar with the Toys R Us franchise of stores – they sell toys and baby stuff. The Wikipedia entry has a good summary.

Their equity is privately held, but they are still required to report publicly because of debt covenants.

Their financial summary is more grim. They are being slaughtered by Amazon and other online retailers, so their heavy physical presence is causing an erosion of sales and pricing power to the point where they are no longer making money during most of the year.

For instance, from the end of January to the end of October (9 months) in both 2016 and 2015, the company does not make money when factoring in amortization (those physical stores and logistics still need upkeep). The interest bite takes an even bigger chunk out of the corporation.

So the Black Friday and Christmas season is critical. It makes the whole year worthwhile in terms of profitability. Even then, in the past couple years it has not been enough to offset losses of the previous 9 months (In 2016 even when factoring in CapEx and interest, they were slightly short of generating cash).

For the most recent holiday season, same-store sales in the all-critical Black Friday and Christmas period were down 2.5% in the USA and more so internationally. This clearly is not a good trend, and one has to ask whether it will continue or whether it was a one-off thing.

I’m ignoring the fact that their balance sheet is a leveraged mess.

Looking at their latest 10-Q, we have an entity in a negative equity situation (negative 1.6 billion), $420 million cash on the asset side and $5.5 billion in long-term debt.

This is a huge mess. The vast majority the debt is secured. There are convolutions of financings behind the various corporate entities under the holding firm, but suffice to say, it is about as leveraged as things get without getting recapitalized. I believe a recapitalization is inevitable.

Somehow, in August of 2016, they managed to convince the 2017 and some of the unsecured 2018 debtholders to exchange their debt for senior secured notes maturing later in time.

It is the 2018 unsecured notes (7.375% coupon) that I was looking at. They mature on October 15, 2018 and there is US$208 million outstanding (about half decided to exchange their debt for 90 cents of par value of secured debt).

The following is a chart of their trading since the exchange offer was floated:

The debt, at the asking price, has a yield to maturity of 11.3%, and a term to maturity of 1.52 years.

This looked like a Pengrowth-ish type situation where you have unsecured debt that may trump the secured debt on the basis of maturity, rather than security. There is a credit facility that has around $630 million remaining that could pay the October 2018 maturity.

Sadly, the risk of a spontaneous credit meltdown is preventing me from purchasing the unsecured debt. One can also make a legitimate case that Toys R Us will burn through enough cash to prevent them from paying off the October 2018 unsecured debt (they have to accumulate inventory for the that Black Friday / Christmas season and this will be when they need the capital the most).

Hence, I will pass purchasing this debt. I’m going to guess it will trade lower over the next 18 months.

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!).

Psychology of Portfolio Management – Doing half

There are some situations in the investment world that result in considerable confusion and risk.

In particular, I am still trying to process the action that has surrounded KCG Holdings (NYSE: KCG) last week. The position appreciated considerably, but there is obviously not going to be any resolution to the matter unless if I wake up one day and a definitive merger agreement has been signed. If the initial proposal and subsequent due diligence cycle does not come to fruition, then there will likely not be any press to that effect and the stock price will drop.

There is a very real reason to hold on (the suggested merger price was lower than my estimate of its fair value), and a very real reason to not hold on (there will be no formal merger agreement). Also, there is no information at all whether this merger would succeed or not, nor any indications on timing.

So the solution was obvious. Sell half.

David Merkel is one of my favourite finance authors and he concisely writes about it in an April 2009 blog post and a subsequent November 2016 post.

This is a perfect situation where doing half applies. The psychological advantage is that I don’t have to cry if there is a better price given to the company, nor do I have to cry if they trade lower (since I know where their fair value rests).

Researching Primary Market offerings

The market has run so dry, it has finally come to this – I’ve had to resort to looking at prospectuses of primary market offerings.

Questrade has a rather interesting link to offerings that they’re trying to peddle to the unsuspecting public. And being the sucker I am for these sorts of things, I glossed through a couple prospectuses.

Hampton Financial Corporation (TSXV: HFC) is trying to raise $20 million in preferred shares (plus warrants on their common shares that are nearly double the current market price). The preferred shares have a perpetual, uncallable (by either side) 8% yield. The head honcho owns a lifetime control stake in the company (and a decent economic interest) and a very sweet-looking employment contract. Try negotiating this on your employer (I’ve replaced the person’s real name with Mr. CEO as I don’t want to foul up his pristine search engine profile on his name):

“In consideration of Mr. CEO’s services, the Corporation has agreed to pay Mr. CEO an annual base salary of $200,000, which is to be increased by a minimum of 25% each year from the first anniversary of the commencement date of the employment and a one-time cash bonus of $200,000 payable at any time during the first year of the executive employment agreement, at the discretion of Mr. CEO. In addition, Mr. CEO is entitled to receive annual bonuses at the discretion of the board which may be paid in part by shares or equity-related instruments of the Corporation and a perquisite package of $24,000 per annum.”

There’s other stuff in the prospectus that is juicy, but suffice to say, I’m not too inclined to support this particular public offering, especially considering they don’t make money and they have about $3 million in stockholder’s equity. They also have some very interesting lawsuits that have judgements rendered which give a very good insight on the culture of the firm.

Who the heck would invest in this? If it actually sells, it’s certainly a sign that the market is willing to pay for anything with yield.

With most of these offerings, keep your hands on your wallet.

(Update, March 21, 2017: At the request of one of the issuers, I have amended this post.)