Rogers Sugar, aftermath

Since Roger Sugar announced its fiscal Q1-2010 results in the middle of February 2’s trading day, the stock has been on a relative free-fall:

The current price of $4.40 is skimming the bottom of my fair value range for the units and it will be interesting to see if it slides below that.

Normal volume for the units are about 140,000 a day, so it is clear that there is some institution or fund that is trying to unload their units. They are not getting much liquidity in the market, which is why the price takes a dive. Opportunistic investors love to wait for moments like these to add to their positions, although it is difficult to game whether the institution or fund dumping units have half a million, or five million units to sell. If the entity dumping units is interested in selling more, they will be pressing the market further.

I would venture that a disproportionate amount of holders of Rogers Sugar are people that will be holding for a very long time, simply because the units do provide a good flow-through entity for investment capital – at a $4.40 unit price, there is a 10.5% yield and even better yet, the yield is sustainable with true earnings.

I also do not think the announcement of the fund considering a distribution cut because of the income trust taxation due 2011 is new news – all profitable income trusts will be doing the same. From my own investment perspective, it will mean shifting units out of my RSP and into my taxable accounts since eligible dividend income is taxed much more favorably than interest income that comes from the trust.

Rogers Sugar reports quarterly result

My largest holding, Rogers Sugar Income Fund, reported a solid but not spectacular quarter. What was odd is that they released the result at 1:30pm eastern time, which was mid-day while the market was open. The market hardly blinked and then a couple hours later there was some minor volume at slightly lower prices to end the day.

The debentures (which I do not own) are trading at around 105% of par value both with a yield to maturity of less than 4%; they do not mature until June 2012 [$50M/6.0%/$5.30/unit conversion] and 2013 [$85M/5.9%/$5.10/unit conversion]. They can be called away at par in June 2010 and 2011, respectively, which is possible if they can secure cheaper financing. The debentures could even be converted to equity if the units trade above the conversion price, which is another possibility. Either way, at present, the solvency of the trust is not in question – they have very good access to credit.

I absolutely love the external reporting style of management – they do a very good job walking you through the GAAP numbers, which are contaminated with inflated and deflated numbers as a result of management’s rigorous hedging of input costs. Management then gives you metrics which separate the timing effects of the hedging. They do it in such a way that is simple, yet elegant, and this is presumably a reflection of CFO Daniel LaFrance‘s style. It is also a textbook example of why GAAP is not the be-all-and-end-all of financial reporting – this will equally be true with the implementation of IFRS (International Financial Reporting Standards), another scheme mainly to enrich accounting consultants and make financial statements even more unreadable than they are presently.

The sugar industry is something that I never quite intended on being relatively knowledgeable about, but over the past few years I’ve accumulated quite a bit of information of the industry, at least of how it applies to Canada. The industry is fairly easy to research, which makes the evaluation of management’s ability to keep costs down and be able to make educate guesses on where the marginal risks are critical, which I think Rogers Sugar has done a good job doing.

Rogers Sugar Income Fund (through Rogers Sugar in Western Canada and Lantic in Central Canada) services mostly the domestic Canadian sugar market – there is one significant competitor in Central Canada (Toronto) in Redpath Sugar and there are also fringe competitors such as Sweet Source Packaging in Toronto, which is under the label of Sweet Source Sugar. The domestic market demand for sugar has been very slowly dropping over the past decade, presumably due to industrial usage shifting toward sugar knock-offs (such as high fructose corn syrup and artificial sweeteners), but otherwise is relatively stable. Despite what one sees at Superstore and Costco, the vast majority of consumption is through industrial usage (such as most of the stuff you would see at Tim Hortons).

Because most countries heavily subsidize their sugar industries, there is a high degree of protection in the industry. As a result, Rogers Sugar, Lantic, and Redpath are able to compete primarily on domestic fronts. There is some small volume of competition that will be coming through Costa Rica through the free trade agreement implemented with them, but it should have a small impact on the domestic marketplace. In addition, the USA and Mexico occasionally open up some component of their own domestic marketplace whenever they face domestic sugar shortages – such as when an adversely located hurricane decides to wipe out their production capability.

Most of the input costs come from importing raw sugarcane from locations south of the USA and processing it into granulated sugar products. In Taber, Alberta, Rogers Sugar additionally harvests and processes sugar beets into raw sugar. The primary cost (other than labour) of refining this raw product comes from the energy consumption required to transform the product – which is through natural gas.

A positive change in price of refined sugar will have a positive impact on gross margins for Rogers Sugar, at the expense of cannibalizing some of the marketplace for substitutable sugar products as those suppliers will convert to high-fructose corn syrup. As sugar prices have been at record highs lately, it remains to be seen whether the positive impact on gross margins will be more or less offset by the reduction in sales volume.

Rogers Sugar gives off a distribution of $0.46/unit (9.75% on the current unit price of $4.72), and this quarter is the first time that management has announced that they are looking into alternative structures with respect to the onset of income trust distribution taxation in Canada. Specifically, they have stated:

We are investigating corporate structures as an alternate to our current income trust structure. Whether we convert to a corporation and as a result pay corporate income taxes or continue with our income trust structure beyond 2010 and become subject to distribution tax, we currently anticipate paying dividends or distributions at levels that would provide an after tax distribution equivalent to that currently enjoyed by our Canadian taxable Unitholders.

This statement implies that their distribution will be reduced to approximately 32 to 33 cents per unit (6.89%). This is a few pennies lower than what I was expecting (mainly 0.46/(1+26.5%) = 0.36 in 2011; 0.46/(1+25.0%) = 0.37 in 2012) but we will see. The company has been doing a good job keeping distributions lower then their free cash flow and have applied the retained earnings into a reduction in leverage – something I find to be a wise decision that will facilitate a much easier refinancing of the debentures.

Merits of the GIC-only investment strategy

I was reading an article on the Globe and Mail about David Trahair, who advocates a GIC-only investment strategy.

Despite the relatively negative income tax implications (the income from the GICs are fully taxable unless if sheltered in an RSP or TFSA), it is not a bad strategy because it can be implemented with a few clicks of the mouse and should provide protection of principal in most situations. It is something even the most unsophisticated investor can perform and you can shop around for the best GIC rates by using a site like GICBroker.com as a guideline for where to get the highest rates.

The only relevant risk worth mentioning is that you are exposing yourself to is inflationary risk (loss of purchasing power of principal), but given the relatively low duration of investment (an average of roughly 3, assuming you are using a GIC ladder) should properly capture heightened interest rate expectations if and when CPI inflation does occur. Right now the best 5-year GIC is a good 100 basis points higher than the equivalent Government of Canada 5-year benchmark bond rate (2.47% vs. 3.5%).

The other comment is that James Hymas makes a very good argument for preferred shares in a portfolio that will diversify the risks associated with having a GIC-only portfolio, and makes for a very good read. Implementing such a change in a portfolio does involve quite a bit of financial sophistication for the do-it-at-home investor, however.

First Uranium will be an interestnig story

Ever since the environmental permit for their tailings mine got revoked by the South African government, First Uranium equity has traded lower. Their debentures have also traded from roughly 75 cents to 71 cents.

Today, however, they will likely trade lower because of First Uranium’s corporate update. In it contains the following words:

The announcement of the withdrawal of the EA has not only delayed construction of the TSF, it has also disrupted certain well-advanced corporate financing opportunities, which, along with the slower than expected production buildup at the Ezulwini Mine, would, if alternative financing is not obtained, severely compromise the Company’s financial position. The Company is now reviewing strategic alternatives, and is engaged in discussions with respect to alternative financing opportunities.

My guess is that the common stock will trade down about 10% on Tuesday and the debentures will trade down another 3 cents. The company will likely have to sell more equity in future gold sales (as they have done previously), or equity in their company in a heavily dilutive offering. Management does not own too much common stock and is likely to dilute through equity to reduce the influence of Simmer and Jack.

The latest financial update from First Uranium was at September 30, 2009. The debentures are CAD$150M and they would be first in line (after a $22M facility) in the event of a default.

The valuation of First Uranium, as its operational woes continue, have to increasingly be looked with respect to what the asset value of operations would capture in the event of a bankruptcy proceeding. As long as the price of gold does not crash, there is value in the operations and debenture holders will likely be able to still make a fair recovery.

Most of the value of the debentures, assuming they are paid, will be in the form of capital gains so keeping these outside the RRSP is likely the best option – at 65 cents on the dollar, your split will be 1 part income to 3 parts capital gains, assuming they mature. Any resulting income will be taxed at around 62% of the income produced from the investment.

Debt and confidence

John Mauldin summarizes a part of the book This Time is Different by repeating that a sudden drop in confidence is what drives economic crises. A lack of confidence is more pronounced in debt crises because if the market collapses for debt renewals, you will have to default, which triggers a worse cascade of events.

It is also difficult to predict when the confidence is lost, but when it does occur, it is usually sudden, as witnessed in the 2008 financial crisis.

Whether another financial-type crash will occur in North American markets is up for debate, but whenever such a crash happens, one is best to brace for impact in terms of one’s portfolio and personal financial situation – high debt leverage is the big killer.

Frontera Copper Note Exchange

Frontera Copper was acquired some time ago by a Mexican company and at that time its common shares were delisted. The company still had some notes outstanding, however. They were defaulted on by the company mainly due to financial issues that resulted from the acquired mine assets not being worth what the acquiring company believed they were worth.

There are two series of notes, both senior unsecured notes, with a coupon of 10% and a maturity date of June 15, 2010 and March 15, 2011. They are trading around 67 cents on the dollar. The company has proposed an exchange offer whereby people can tender their notes and receive 90 cents of face value (if tendered early) of new notes earning 10% interest, maturing December 2012. The terms also include that if copper goes below US$2.90/pound, the notes will give 6% interest. Also, the notes will be repaid in 25% installments, starting 18 months after they are issued, and can be extended by another 6 months if copper is below US$2.35/pound. Finally, if the notes are exchanged, unpaid interest on the previous notes will be paid.

The new notes will also be secured by a second-in-line interest on the mine assets after the bank loan, but this security is likely not worth too much.

The only kicker is that the new notes will not be exchange traded.

I am not seriously interested in these notes or the exchange offer, but thought it was an interesting offer. The fact that the market price for these notes plummeted when they announced this offer suggests that the bond market will not be expecting they will be paid in full, despite the effective 13-14% current yield they will receive after the exchange offer. Also, liquidity risk is a serious consideration with respect to the untradable nature of the notes. Finally, the international nature of the notes in question (essentially being secured by a Mexican operation and a Mexican corporation) leaves jurisdictional risk issues in case if they decide to default – who do you end up suing? A worthless BC shell corporation when the assets are held in a Mexican corporation?

It are risk factors like these that made me pass up the risk on this offer, but it might be for some other people to analyze and make a killing if the deal actually works for noteholders.

Fixed income comparisons

There are some exchange traded products that are functionally identical but have different market prices. The reason why the prices are different is because of the individual demand/supply characteristics of the securities and individual liquidity preferences – for example, if two issues were otherwise identical in maturity date, coupon and seniority, if one issue was $200M outstanding, while the other was $20M outstanding, you would expect the $20M one to trade for less because of liquidity preference.

Right now on my radar screen, I see 7% coupon, 2028 maturity trust preferreds (backed by corporate senior debt, par value $25) trade at bid/ask 19.1/19.41 for one issue and 19.70/19.94 for another issue. Using the midpoint, we have a 9.83% yield to maturity for the first, and a 9.51% yield to maturity for the second.

The only reason why I am not hammering this difference is because they are non-marginable and you cannot short sell them.

Even more complicated is another issue that has identical characteristics, except it gives off a 6.5% coupon. At the current bid/ask of 17.37/17.50, we get a yield to maturity of 10.29%, which makes it more of a bargain than the other two securities – as long as you are willing to take your returns in the form of capital gains instead of coupon payments. In Canada, for taxable accounts, this is favoured. The cost of this, however, is that lower coupon issues are more sensitive to interest rate changes.

What is interesting is that if the securities in question were zero-coupon, with a 10.29% yield to maturity they would be priced about $3.965/share, while at a 9.51% yield to maturity, they would be $4.531/share, a 14.3% difference. It pays to shop around for your fixed income!

Handbook of Fixed Income Securities

I borrowed from the library the “Handbook of Fixed Income Securities” (Fabozzi) and while I didn’t go through it cover-to-cover (it is as thick as a phone book), I did find his style very good, especially with examples. The art of determining what risks you are taking in the fixed income market is highly quantitative and without the quantitative backing, the benefit you may get out of the book would be limited.

History of stock market crashes

October 28-29, 1929: Marked the beginning of the great depression – although the worst of it was only a couple years later, this was a very powerful signal that something wasn’t right in the US economy. This was characterized mainly by a lot of margin debt purchasing and rampant speculation on equities.

1973 to 1974: Marked the beginning of the rise of OPEC, and concerns about the world supply of crude oil in general. Also marked the beginning of the modern currency exchange systems we see today. This was in the middle of a recession and a period of high inflation (these two together are referred to as “stagflation”) and is the worst possible combination for equity markets.

October 19, 1987 (aka “Black Monday”): Probably the only “true” random market crash, potentially caused with inexperience with complexity through computer program trading, and also the Treasury Secretary mumbling about having to devalue US currency. Federal reserve chairman Alan Greenspan was also new on the job at this time. The US recovered despite having lost 22.7% of its market value for the day. Hong Kong got killed by 45.8%; in all cases buying this crash would have been fruitful. Easy to say when looking at past charts!

October 13, 1989: A small random market crash (6.1% loss on the S&P 500) for no particular reason at all.

October 27, 1997: The S&P lost 6.9% due to the Asian currency crisis and panic selling. This was at the time of the beginning of the run-up in technology issues. Although this was somewhat interrupted by the Long Term Capital Management fiasco in 1998, equities never looked back until February 2000, where they peaked.

September 11, 2001: The largest terrorist attack on US soil, and the biggest death count since the Pearl Harbour attack in December 1941. Equities dropped when markets re-opened a week later, mainly due to insurance and financial firms that had to perform some massive re-balancing after liquidating assets. This would prove to be a local bottom, but not a true bottom until in 2002 when markets finally reached their lows for the decade (up until the 2008 financial crisis).

October 2007 to March 2009: Fresh in everybody’s memory, the financial crisis caused wholesale liquidations in major financial firms, such as Bear Stearns, Lehman Brothers, Wachovia, Washington Mutual, etc. From peak to trough, the S&P 500 lost 56% of its value.

… and after this history lesson, will January 25, 2010 be on the books?

Obama wants to take out the stock market

Now that Barack Obama is done demolishing the US fiscal balance, he’s now going to work on demolishing the US stock market. Just a couple days after losing the Massachusetts senate election, the rumblings of the administration wanting to crack down on finance companies is hitting the pipeline, and we are seeing it in the form of rises in implied volatility. Here is a 5-day chart of the S&P 100 30-day implied volatility (otherwise called the VIX):

It will be very, very interesting to see how this gets played out. Volatility is good, as long as you can predict whether markets go volatile “up” or volatile “down”!