A very quiet May and some self-reflection

It has been a relatively calm month of May for me – I know the cliche of sell in May and go away has resonated in my mind, but my positioning is still quite defensive (very heavily weighted in preferred shares and corporate debt). One advantage of such a defensive portfolio structure is that it is relatively insulated to equity volatility.

The past three months have seen quite a significant performance gain and when there are gains this large I always ask myself whether it is sustainable. When I look at the fixed income components of my portfolio, I see higher room for appreciation from current levels as markets continue to normalize. For whatever reason, Canadian markets were heavily sold off in early February, especially in the fixed income space, and we are still continuing to see a normalization of these valuations.

There were a few missed opportunities on the way. I will throw out a bone for the audience and mention I was willing to pounce on Rogers Sugar (TSX: RSI) when it was going to trade below $3.75/share, but clearly that did not happen (sadly, its low point was $3.84/share) and it has rocketed upwards nearly 50% to $5.71 presently on the pretense that Canadians are going to have a sweeter tooth for sugar rather than corn sweeteners in the upcoming months (which is true – their last quarterly financial statements show an uptick in business and this should continue for another year or so and the market has priced this in completely).

My overall thesis at this point is that the aggregate markets will be choppy – there will not be crashes or mega-rallies, but there will be lots of smaller gyrations up and down to encourage the financial press that the world will be ending or the next boom is starting. When looking at general volatility, the markets usually find something to panic about twice a year and we had a large panic last February. The upcoming panic would likely deal with the fallout concerning the presidential election.

If net returns from equity are going to be muted, it would suggest that the best choices still continues to be in fixed income. The opportunities at present are not giving nearly as much of a bang for the buck in terms of risk/reward, but there are still reasonable selections available in the market. A good example of this would be Pengrowth Energy debentures (TSX: PGF.DB.B) which is trading between 94 to 95 cents of par value. Barring crude oil crashing down to US$30/barrel again, it is very likely to mature at par on March 31, 2017. You’ll pick up a 6% capital gain over 10 months and also pick up some interest at a 6.25% coupon rate. Worst case scenario is they elect a share conversion, but with Seymour Schulich picking up a good-sized minority stake in the company, I very much doubt it. (Disclosure: I bought a bunch of them a couple months ago at lower prices).

In the meantime, I am once again twiddling my thumbs in this market.

Rogers Sugar – Freefall

I used to own shares in Rogers Sugar, back in the days when it was still trading as an income trust. I had a slab of units in the mid 3’s and sold them in the mid 5’s, citing that the upside was probably limited from that point. This was one of the companies that I loaded up on during the economic crisis and it paid off. My selling timing wasn’t ideal as they’ve managed to get up to about $6/share before moderating:

rsi

I’ve been asked whether this company is a buy or not. Normally I don’t entertain these requests, but since I don’t need to do any additional research on this company that I’ve already written about, I’ll comment.

The quick answer is that they are trading within my fair value range. They’ve been well over my fair value range for the bulk of the last couple years. My theory here is that they were perceived as a safe stock with a safe yield, and lumped into every income fund manager’s portfolio as something reliably yieldy but “without risk”. I would say the assessment of income is correct, but the assumption of risk is not, and the market clearly has shown that over the past two weeks of trading.

I’m not sure why they got killed as badly as they have. Their last quarterly report (the catalyst) was not good, but the stock didn’t deserve the 20% bludgeoning they took. There is clearly a lot of other technical factors going on here (stop losses, value investors dumping, margin players dumping, etc.).

Market-wise they are facing a few adverse factors (the crops down south have been better than usual, which will cause over-supply and hence no exports for this year), and also Redpath is seemingly getting good at marketing and beating Rogers – heck, I even notice their product in the local Costco. These margin pressures are not good for the company, but this is the nature of the industry and it has been this way for a long, long time.

They will have to go down further before I’ll consider buying shares.

Also for those wanting to do some fundamental research on the company, just note that reading the GAAP income statement is nearly useless due to the use of derivatives the company engages in to hedge natural gas pricing.

A rare article on the Canadian sugar industry

Investors in Rogers Sugar (TSX: RSI) will doubtlessly be interested in reading this article in the Globe and Mail.

In my past, I have put in more time and effort into understanding the sugar industry in the country and the protection that both marketplaces (Canada and the USA) have on their sugar industries are very relevant factors in terms of Rogers being able to compete. Rogers Sugar has a virtual monopoly on the Western Canadian operations because of transportation logistics, while on the eastern part of Canada (Ontario, Quebec) there is competition between Rogers, Redpath, and a lesser competitor called Sweet Source Sugar.

After the Canadian trade panel ruled against the domestic sugar industry’s wishes by opening up the Canadian market to EU imports, I was actually quite surprised at the decision. I was even more surprised when the sugar producers appealed and managed to overturn that ruling. This alone was worth quite a few pennies on Rogers’ stock price – mainly the implied degradation of pricing power as Canada continues to open up its borders. For instance, there is a free trade agreement between Canada and Costa Rica which will enable the duty-free import of a relatively small supply of sugar, providing that it is produced from Costa Rica. Other free trade agreements that are pending the sugar industry has been able to flex some regulatory muscle to get specific provisions against opening domestic sugar into such agreements (Columbia being one example).

From an investment perspective, I sold my sizable portion of Rogers around the 5.50 range, but continue to watch the stock, albeit, it is a rather boring company to track. If there is a hiccup in the future (and there may be considering that some of its domestic production is derived from Alberta-grown sugar beats and thus represents a slight amount of operational risk) that takes the stock price down, I may get interested again. But at $6/share, there isn’t a heck of a lot of capital upside in exchange for a 6% yield.

Rogers Sugar

The last little bit of my longest-term holding, Rogers Sugar (TSX: RSI) I have unloaded today. The company is very well run, but substantially all of its free cash flow is sent out the window in dividends – at a yield of roughly 6-6.1%, historically this is expensive and by virtue of being in the sugar refining industry, isn’t exactly in a position to dramatically expand revenues and earnings.

Investors are paying bond-like premiums for equity-like returns. At the rate that yield-chasing is going, investors might even bid up the company to 5.5% or even 5%, but I won’t have any part of it. The golden moment was when in early 2009 it was trading at $3/unit and I did load up during this time since the stable 15% pre-tax returns made much more sense in terms of valuation. The only problem was that most other equities at that time were also exhibiting high risk-reward potential!

Dangers of buying callable debentures above par value

Rogers Sugar (TSX: RSI) announced at the end of trading they had a bought offering of debentures, and calling in their existing series of debentures (TSX: RSI.DB.B) effective around December 19, 2011.

Holders of RSI.DB.B will be receiving a nasty shock tomorrow because of this call announcement – they were trading around 104 before this happened, but now the debentures will only be redeemed for 100. Any recent buyers of the debentures will take a bit of a loss. The debentures were trading slightly above par because of the conversion feature embedded within them – they are convertible at $5.10 per share and with the market price recently at $5.14, it is possible there may be further conversions. The debentures will trade at 100 plus the embedded value of a call option that expires on December 19, 2011.

The deal itself is very good for Rogers Sugar – they have extended the term structure of their debentures to April 2017 and December 2018, done so at a slightly lower coupon rate, and an increased conversion price ($6.50 and $7.20 per share, respectively). Overall, Rogers Sugar has performed excellent in my portfolio and I continue to hold a position in the equity, albeit the equity is in my fair value range. Although the investment has been about as exciting as watching paint dry, they have performed solidly.

Payment for liquidity – anatomy of a margin call

When you go to a bank and ask for their rates on 1-year GICs, you usually get two responses – the rate for the cashable GIC and the rate for a locked-in GIC. You will receive a larger rate if you are willing to commit your money for a longer time period, at the penalty of having no interest if you want early access to your cash. The rate differences can be considered a payment for liquidity.

In the stock markets today, people are paying heavily for liquidity.

As an example, one of my top holdings, Rogers Sugar (TSX: RSI), tanked in trading because somebody needed liquidity, fast:

At 9:56 (eastern), the bid/ask was already being pushed down. It was at bid/ask 4.90/4.92 and then somebody wanted to get rid of about 100,000 shares quickly. In the span of five seconds, they took down the asking price 44 cents to $4.50 and then in the course of ten seconds there were 58,190 shares traded between 4.46 and 4.90. The bulk of the trade was done at the price of $4.50 where 35,400 shares changed hands.

This is the type of trading activity that occurs when somebody is undergoing a margin liquidation. They are paying a 40 cent per share premium for the privilege of wanting cash right now.

Generally speaking if you were on the opposite ends of these types of liqudiations you will receive a very, very good price. However, the window of opportunity you actually have to react to such liquidations is very, very tiny – you had about 1 second to hit somebody’s ask at 4.50 before somebody else picked it up. This is why computer trading is so prevalent in the marketplace – they are out there looking for such prospects.

When the market needs liquidity it does not matter what the fair value of the underlying security is – it will go at whatever price others want to pay for it. This can be much lower than the existing market value or what would be a rational valuation for the underlying company.

Analysis of Rogers Sugar

I notice that a couple weeks ago Susan Brunner did an analysis of Rogers Sugar (TSX: RSI) (Part 1, Part 2). I generally like reading what Susan writes simply because she is very rigorous and quantitative. I am pretty sure that she does some more digging “underneath the hood” in the companies she profiles.

In the event of Rogers Sugar, I have been an investor in units since 2007 when it was still an income trust. I added significantly to my position during the 2008-2009 economic crisis. Although I have trimmed my position somewhat early this year, RSI is still a significant holding in my portfolio and I do not anticipate this changing unless if there is appreciation in the share value from current prices. The company is currently trading slightly above the upper end of my fair value range.

There are a few salient details which looking at the balance sheet and income statement will not bring up in a cursory analysis. This requires some knowledge about their business model. The company imports raw sugar cane (typically from Brazil) and also produces its own sugar beets (in Alberta) which is manufactured into sugar in its Taber, Alberta facility. Sugar cane is manufactured into sugar in Vancouver and Montreal.

The company makes extensive use of hedging to shelter volatility in cost inputs, particularly raw sugar and natural gas. As a result, due to GAAP accounting practices (and IFRS, which makes statements even more difficult to read) income streams are very volatile as contract values rise and fall. This makes quarterly income figures almost meaningless to compare from quarter to quarter and has little to do with the economic performance of the company. As a result, management provides in the MD&A documents an “adjusted gross margin” figure which is much more comparable from quarter to quarter. An example of the most recent quarter is as follows:

Q2-2011 was not very good, but volume has been relatively steady from 2010. The reason for the lackluster performance is because management has had a difficult to managing the volatility of sugar prices (see below):

Overall performance has also been hampered retrospectively from its full potential by management hedging natural gas pricing in an environment where spot pricing has been significantly cheaper than pricing a year or two out.

The company is in a duopoly situation with another major competitor in central Canada, and one other minor competitor. There is no real competition in the western half of the country. This, combined with adequate protection against international sugar trade (duties for US sugar imports make US competition prohibitively expensive) make Rogers Sugar economically very stable to invest in. There are signs of erosion from free trade agreements in Latin American countries and possibly the European Union, but so far this has not materialized and such threats have been present for a very long time. Despite its economically sheltered position, margins are relatively slim – 2010’s fiscal year had a 7% after-tax profit margin with the assumption that the income was fully taxable (the income trust structure sheltered most of the taxation until the end of 2010, but the statements have retrospective treatment of income tax provisions for comparability).

Finally, the company has $78M of 5.9% convertible debentures outstanding (TSX: RSI.DB.B) that mature on June 29, 2013. They are convertible into shares at $5.10, or about 15.3 million shares. The company has the right to call them at par value at any time (with 30 days notice). While the company should have no problem refinancing the debt, the overhang will likely serve as a drag on further share price appreciation. For the company, it also brings up a cost of financing issue since the interest bite on the debentures is $4.6 million per year pre-tax, while if converted the shares will pay an after-tax dividend of $5.2 million (and at a 25% stauatory tax rate, that translates into $6.9 million).

As sugar prices have continued to remain high, if the company is able to harvest its sugar beet crop in sufficient quantity, there would be a boost to gross margins and this is likely somewhat reflected in the existing stock price. It is likely that while there is some expectation of this already baked into the price, it is probably not priced in fully yet. If you have read this far, this is a predictive comment and actionable information if you care to speculate.

Management is very experienced in the industry and the key/controlling shareholder (Belkorp Industries, run by Stuart Belkin) owns a 12% stake in the common shares (but has the right to nominate a majority slate of directors in the operating company) and there is sufficient alignment of interests with non-controlling shareholders. Management compensation is fair, aligned to performance, and dilution has been kept to a minimum. I am surprised that the company hasn’t been taken private in a leveraged buyout when unit prices were lower, but at present prices this is not likely to happen.

While the company should have no problem paying out their cash dividend, given the nature of the industry, one would not want to hold onto Rogers Sugar if they are expecting a double in the price of their shares. Hence, Rogers Sugar is not a growth company, but rather a very stable income producer held in a non-registered account.

Rogers Sugar announces 3rd quarter results

Rogers Sugar Income Fund announced their quarterly results yesterday. The operational performance is not relevant to this post, but rather the announcement of how they will be treating their distributions after 2010 is over:

Management of Lantic and the Board of Trustees of the Fund continue to work on a plan to convert from the current income trust structure to a more conventional corporate structure. This conversion is expected to be effective as of January 1, 2011, in order to allow the current Unitholders of the Fund to maximize the benefits of the current income trust structure. The current intention is to pay quarterly dividends of approximately $0.085 per share, in order to maintain cash dividends to shareholders of the converted structure at levels that would provide an after-tax distribution equivalent to that currently enjoyed by our taxable Canadian Unitholders. The amount of dividends paid following the conversion will be at the discretion of our Board, and will be evaluated quarterly and may be revised subject to business circumstances and expected capital requirements depending on, among other things, earnings and other conditions existing from time to time.

Currently the distribution rate is $0.46/unit of interest income. At yesterday’s closing price of $4.91/unit, this translates into a 9.37% yield. A $0.085/quarter dividend translates into $0.34/year, or a 6.92% dividend rate. This is also a 26% haircut from the current payout rate. This is relatively comparable to other businesses that are publicly traded and give out dividends representing most of the free cash flow of the corporation.

The following table is a before-and-after concerning a unitholder’s after-tax distributions in British Columbia, assuming the units are held in a non-registered account, using 2010 rates (which is a critical assumption of this model, 2011 marginal rates will be slightly different due to changes in the dividend tax credit):

After-Tax Income:
Income Range Marginal Rates $0.46 $0.34
Low High Income Dividends Income Dividend Difference:
$ $ 35,859 20.06% -12.59% $ 0.368 $0.383 (0.0151)
$ 35,859 $ 40,970 22.70% -8.79% $ 0.356 $0.370 (0.0143)
$ 40,970 $ 71,719 29.70% 1.29% $ 0.323 $0.336 (0.0122)
$ 71,719 $ 81,941 32.50% 5.32% $ 0.311 $0.322 (0.0114)
$ 81,941 $ 82,342 36.50% 11.08% $ 0.292 $0.302 (0.0102)
$ 82,342 $ 99,987 38.29% 13.66% $ 0.284 $0.294 (0.0097)
$ 99,987 $ 127,021 40.70% 17.13% $ 0.273 $0.282 (0.0090)
> $127021 43.70% 21.45% $ 0.259 $0.267 (0.0081)

As we can see, the after-tax dividend post-2011 is slightly higher than the pre-tax income distribution for all income brackets.

Also, as I have written before, anybody holding income trust units (other than REITs) in their RRSPs and TFSAs should be moving them into their non-registered accounts at the beginning of 2011.

After-Tax: After-Tax:
Income Range Marginal Rates $0.46 $0.34
Low High Income Dividends Income Dividend Difference:
$ $ 35,859 20.06% -12.59% $ 0.368 $0.383 (0.0151)
$ 35,859 $ 40,970 22.70% -8.79% $ 0.356 $0.370 (0.0143)
$ 40,970 $ 71,719 29.70% 1.29% $ 0.323 $0.336 (0.0122)
$ 71,719 $ 81,941 32.50% 5.32% $ 0.311 $0.322 (0.0114)
$ 81,941 $ 82,342 36.50% 11.08% $ 0.292 $0.302 (0.0102)
$ 82,342 $ 99,987 38.29% 13.66% $ 0.284 $0.294 (0.0097)
$ 99,987 $ 127,021 40.70% 17.13% $ 0.273 $0.282 (0.0090)
> $127021 43.70% 21.45% $ 0.259 $0.267 (0.0081)

Paying attention to debt call features

Rogers Sugar Income Fund announced yesterday a bought deal – they were issuing $50M in convertible debt. The salient part of their press release was the following:

The net proceeds of the offering will be used to redeem all of the outstanding $50 million principal amount 6.0% convertible unsecured subordinated debentures of the Fund due June 29, 2012. The redemption is intended to take place on or about June 29, 2010.

The $50M currently outstanding trades as RSI.DB.A. It had a maturity of June 2012, coupon of 6% and a conversion feature at $5.30/unit – before this announcement, the debt was trading very thinly at a price of 103-104. This implies a 4.1-4.5% yield, plus the option premium on conversion. The proper valuation of the debt actually is not a trivial issue considering you have to make some complex calculations with respect to the convertible option – Black Scholes will not cut it in this case.

In any event, Rogers Sugar refinanced the debt. The June 2012 debt also contains a call option, where the company can call the debt, as per the prospectus:

On or after June 29, 2010, the Debentures will be redeemable prior to Maturity in whole or in part from time to time at the option of the Fund on not more than 60 days and not less than 30 days prior notice at a price equal to the principal amount thereof plus accrued and unpaid interest.

So in other words, debt that was trading between 103-104 on March 18, 2010 will be redeemed at a price of 100 by the company on June 29, 2010.

Not surprisingly, the debt now is trading with a bid/ask of 101.75/102.00 and the only reason why this is above 100 is purely due to the value of a three month option with a strike price of $5.30/unit embedded in the debt. Debt purchased at 102 actually has a negative 0.5% yield when you factor in the call that will occur on June 29, 2010.

Investors would be very well to take note of any embedded call features in the debentures they purchase – especially if they are purchasing the debt for over par value.

The new debt issue of Rogers Sugar has a 7 year maturity and is 2.7% above government bond rates (coupon 5.7%; government 7-year benchmark is 2.96%), which is represents a rather cheap medium-term financing for the company. The $6.50/unit call premium is about 35% above market value and thus would minimize any dilution in the unlikely event that Rogers Sugar actually trades that high and thus the coupon cost is lower. I would have preferred that management lower the conversion rate to about $6.00/unit and have a smaller coupon on the debt, however.

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.