Author Archives: Sacha Peter

Timing of the market downturn

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Likely due to the Greece situation in Europe and anticipation of financial disruption, the markets are raising cash like no tomorrow by liquidating everything that can be liquified.

Naturally, this has gotten me somewhat interested in the markets again from a broad perspective.

Something fascinating is that anything relating to crude has been hammered for the past month. For example, Canadian Oil Sands (TSX: COS) has a relatively boring business that has been disproportionately traded down in relation to crude prices. An example is that a year ago you could have bought a share of COS for about 0.29 barrels of spot crude and today that ratio is 0.22.

This is generally the same effect that is seen with investors in gold – the underlying commodity is the volatile component while the stocks that produce the commodity are underperforming (Barrick, Kinross, etc.).

I don’t have much comment on COS other than that while it does seem like it is trading relatively cheap, my gut feel suggests that it can get even cheaper – especially if the unthinkable occurs. The unthinkable event in everybody’s mindset today is that the price of crude oil will make a significant fall. It’s similar to how nobody anticipated how low natural gas prices could go (and indeed, even lower than the economic crisis point), and how Canadian 10-year bond yields could not get lower than a very low 3% (they are now at 1.93%).

The other comment is that a good investor makes money by deploying it at the relative trough of a period of panic and crisis, and holding on for dear life until things feel rosy again, and then selling and going away until they see the panic and crisis again.

The problem is that it is very difficult to identify moments of panic and crisis, and even when you know you are in the middle of it, you still don’t know whether it can get worse than what you are seeing. It is expensive to be early to the party. One particular barometer that I use as a guideline (and many others do as well, so the information content of this proxy is somewhat diluted) is the VIX:

This would suggest we’ve got some way to go before deploying capital would be wise. I also still don’t see hints of any panic simply by looking at corporate bond yields – nothing is breaking in that department yet.

But assembling that watchlist would be a good idea. And this time, my instinct would be to go for non-commodity, non-yielding securities. And certainly not Facebook equity.

Converting crap to cash

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I think everybody has a lot of spare junk that they wish they could click a button and just sell. It is also cumbersome to list items on Craigslist since there is a lot of filtration required. Likewise, Ebay is no longer a good place to get rid of unnecessary garbage since competitive forces have rendered markets full of supplies of garbage that nobody needs.

Scale this problem up by a factor of a thousand and you have companies with warehouses full of garbage they don’t need. So insert in a company like Liquidity Services (NYSE: LQDT) and take a look at what they’ve done since the economic crisis:

Suffice to say, the horse is completely out of the barn now and the company will be facing the law of large numbers soon (i.e. growth percentages are going to slow down), but I just found this interesting. Companies finding profitable ways of getting rid of junk assets (either through re-selling them or otherwise trashing or recycling them) should continue to do well.

JP Morgan and large financial companies

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One reason why I don’t own companies like JP Morgan (NYSE: JPM) is because you truly don’t have a clue what’s going on inside these companies. Even top management (such as Jamie Dimon) has to find out through a relatively roundabout way that some of his employees have blown away $2 billion in equity making trades they presumably thought were hedging some other risk but turned out not to be.

Can anybody with a straight face look at their 10-K and make heads or tails of it?

In essence, when you invest in these types of companies you are really taking a leap of faith that the assets they claim to have are real and collectible, and that the liabilities aren’t misstated in such a way that causes them to pay out more than what you see on the books. You are also taking a leap of faith that their loan portfolio takes in more income than they pay out to depositors.

On paper, you are paying $37/share for a company that analysts (before this 50 cent per share trading loss) believe will make $4.97/share this year and $5.60/share next year. Let’s pretend this is true. Sound cheap? Sounds like it, but ultimately do you really know what you are purchasing?

You are buying an implicit guarantee that JPM will crank up its dividend yield over a period of time and hopefully rack up some capital appreciation since its earnings are significantly higher than its dividend payout. The question is – will the company blow up? JP Morgan blowing up doesn’t seem all that likely right now, but just ask people that invested in Bear Stearns, Merrill Lynch, Wachovia, or Washington Mutual five years ago, where an implosion equally seemed unlikely. Who knows? I don’t, and that’s why I’m staying away from these true leap of faiths like JP Morgan equity.

This type of thinking applies to most large cap financial companies, including the large Canadian Banks (specifically, TD, RY, CM, BMO, BNS and to a lesser degree NA and CWB).

That said, you can also invest in these large capital financial firms as a variety of a Pascal Wager where if companies like JPM collapse (or one of the big five Canadian banks) that there is going to be so much collateral damage that subsequently earning a return on investment is not going to make much difference since you’ll be hiding in your underground bunker while civilization collapses around you.

Chesapeake Energy – Fishy

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The saga with Chesapeake Energy (NYSE: CHK) continues – today they released their 10-Q filing where the new pronouncement was that their asset divestiture program was taking a bit longer than expected. The market subsequently took them down 14%, which took them down into lows not seen since the 2008 financial crisis (and the CEO’s infamous margin call which I wrote about earlier).

The company subsequently announced later that day they inked an agreement with Goldman Sachs for a $3 billion credit facility that is on par with the senior bondholders – at an initial rate of LIBOR plus 7%, which is currently 8.5%; this rate will go on for the calendar year and presumably will dramatically increase thereafter.

When glossing over the 10-Q, the imminent need for liquidity appears to be the voracious cash-guzzling appetite of its capital expenditures – $3.7 billion in the quarter alone, offset by about $274 million in cash flows through operations. Ouch.

Also, looking at the balance sheet makes me wonder why they have more in payables than receivables, usually not a good sign.

Goldman Sachs is giving them liquidity at a high cost and presumably they’ve been smart enough to look at their books and loan them money at an appropriate level of capitalization. This does not, however, bode well for the equity holders. My intuitive would suggest there is a lot more garbage going on within the company that shareholders aren’t going to be exactly receptive to. This might look like a deep value play given the purported value of its assets, but if you’re taking money short term money from Goldman Sachs at 8.5%, the other side of the negotiating table is going to see this and realize you might be more desperate than it seems to get rid of your assets.

The company also gives out a 9 cent quarterly dividend, which amounts to $240 million a year, which will now be financed by this Goldman Sachs bridge loan.

No positions in CHK, although I’ve done a little digging and don’t really like what I see.

Rosetta Stone

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My first equity purchase in 2012 was Rosetta Stone (NYSE: RST) at a basis of approximately $8.50. I had started accumulating shares at the $7.50 to $7 range and was hoping to obtain more of a position, but unfortunately the stock slipped away and the last pieces I acquired was at the $9-$10 level. My original wish was that their stock would decline down to $6.50-ish where I would have obtained a full position, but instead I got about half of my desired position, at a higher than desired basis – c’est la vie!

The company was compelling for a few reasons:

1. They had a well known, existing franchise in a sector (language learning) that clearly would benefit from globalization and not be whittled away by other companies’ offerings (which exist and are relevant competition);
2. Their balance sheet was very clean, having (assuming the $7.50 price point) about $100 million in the bank and a market cap of about $160 million; this means an investor was paying for very little to own the underlying franchise;
3. And speaking of the franchise, it is a $250M/year business selling software. Similar to selling pharmaceuticals, software tends to be a very capital-intense up-front business, and the main operating expenses tend to be sales and marketing. So for the princely sum of about $60 million, you could buy into a business at a P/R of about a quarter, fairly cheap if you assume that the software asset is actually worth anything (and indeed, it is, you just can’t see it on the balance sheet since R&D expenses are mostly expensed away and not capitalized).
4. Google Translator and other such “free” services (such as speaking into your iPhone) doesn’t really intersect too much with the language learning software market. If anything, these free services are a compliment.

There were some negatives, including:

1. The previous history of the company being an LBO target and then going public again; there were significant shareholders in the corporation that are actively divesting their interest. Correspondingly, management doesn’t have too much of an ownership stake in the firm – the new CEO has about a 1.5% stake in the company, while the former CEO has about 5%;
2. The profitability of the company has been low, but this is primarily due to marketing expenses;
3. Penetration into international markets has been less successful than originally desired by management;
4. Pressures dealing with US markets (specifically those somewhat exposed to government funding such as education);
5. Management changes – the CEO at the top recently stepped down and they have internally promoted their CFO to CEO and recently hired a new CFO.

I’ll leave out the hard-core quantitative metrics. I’ll condense it by saying the company appeared cheap at their single-digit valuation. Since I’m no longer interested in accumulating shares, I’m holding it in my portfolio since my price target has not been reached yet even with the past week’s action where a relatively rosy quarterly report took them up 30% and I am revealing this holding to the world.

All I have to do now is find 6 or 7 of them and start using the cash balances and who knows, 2012 might turn out to be profitable compared to the (relative) disaster I had in 2011.

Still watching and waiting

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My writings have been relatively less frequent over the past month, but this is because I’m waiting for some opportunities to reveal themselves in the marketplace. There has been some renewed volatility over the past couple of weeks and some momentum-reversing trends (e.g. spot natural gas is finally showing an uptick), but other trends are back to their usual self (e.g. US 30-year treasury bonds at a very low 3% yield).

All I know is that reaching for yield becomes more and more risky. Avoid the yield since it is most likely an illusion that will give you a few pennies of income in exchange for a few dollars of capital.

Yellow Media – Stick a fork in the stockholders, they are done

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Yellow Media (TSX: YLO) released their first quarter results, and suffice to say, anybody owning equity or debt in the company should be hurting tomorrow.

While the headline EBITDA result of $146 million may seem positive, all other metrics suggest a “steeper than expected” softening of key metrics. I will take some direct quotations from their MD&A:

The decrease [in revenues] for the three-month period ended March 31, 2012 is due to lower print revenues, especially in urban markets where revenues declined at a much higher rate than rural markets. We have identified new trends, which indicate that the print decline will be more rapid and enduring than previously anticipated.

I like the statement “we have identified new trends” since it implies that management did some deep research to discover this when it seems pretty obvious the company had to identify this by experiencing it directly.

Online advertisers, who in the past, purchased our legacy online products, are not migrating to our new products as quickly as we had anticipated. This now suggests that the online revenue growth will be slower than we had projected [...] Online revenue growth is not expected to compensate for the declining revenue in our traditional print offerings in the near future.

Uh-oh! Could it be the case that the online advertising market is a hell of a lot more competitive?

In terms of the numbers themselves, the focus should be on the balance sheet: The company on March 31 had $310 million in cash, and on May 7 had $292 million in cash. When you account for the fact the company made a $25 million payment on their non-revolving credit facility, it actually implies they generated $8 million during those 5 weeks. I wouldn’t extrapolate this for the whole year!

The “adjusted earnings”, which is roughly a modified free cash flow calculation, was $67.3 million, down from $133.6 million from the quarter in the previous year. While the company is still generating a good deal of cash, the amount is declining at an alarming rate.

I ignore the $3 billion write-down of goodwill – for the uninitiated, they will now see the $785 million stockholders’ deficiency when normally they are accustomed to seeing it called stockholders’ equity. Any analyst worth his/her salt would have made that mental adjustment from day one, and this will hopefully silence the lunatics citing Yellow Media as a good value because of its exceedingly good price to book ratio.

In the raw calculus, the company has $292 million in cash, and they have to pay back $394 million by February, 2013, another $130 million by July 2013, and $125 million by December 2013. If you take the optimistic approach and assuming their decay in cash generation will flatten, they can barely pay off the maturities to the end of 2013, but who in their right mind would believe that things have flattened out?

The company is most likely going to go into some form of restructuring that will address its debt issues. This is likely to be very punitive toward equity holders and also the subordinated debenture holders. They will probably be given a few scrap bones to expedite the process.

Medium term notes are at around 67 cents for the near maturity, and about 60 cents for further maturities on the ask. Debentures are at 17 cents, and perpetual preferred shares (TSX: YLO.PR.C / YLO.PR.D) received a speculative spike over the past few days from 3 cents of par to 4. Suffice to say, the dividends on those preferred shares aren’t coming back anytime soon.

Thankfully, no positions in YLO – I’ve already taken my lumps previously and am just watching how this very unusual financial train wreck unfolds.

Chesapeake Energy – What a basket case

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Chesapeake Energy (NYSE: CHK) is the second largest natural gas producer in the USA.

It has a few claims to fame. The most positive and negative aspects of the company seem to be directly related to its CEO, Aubrey McClendon. Concentrating on the negative side of the story, is that McClendon formerly owned about 5% of the company, got liquidated out on a huge margin call in the 2008 economic crisis. He was forced to liquidate his stake in the company at very adverse market prices. This would be a pretty good signal to anybody that the main person at the top is one tremendous risk-taker, but that risk is a double edged sword.

The corporation’s board of directors are directly in McClendon’s pocket as they subsequently awarded him a $75 million bonus in deferred compensation relating to well drillings and other such matters, but this presumably related to rubbing a salve on the huge financial wound that was incurred back in 2008.

His financial troubles have recently re-emerged when it was revealed that he had partial ownership stakes in natural gas wells that were also jointly owned by the corporation and this created a conflict of interest with respect to liquidation. Basically the conflict is that McClendon was in a position to front-run his own company or otherwise receive preferential treatment. Compounding the matter was the rumour that he apparently has a billion dollars that he loaned to take such an interest in these wells.

It is not helping the company that natural gas prices have reached record lows, which will be depressing the company’s profit margins.

So why the heck would anybody want to invest in this basket case? The only rationale is that investors would have to believe that the board of directors would be overturned and they would be able to no longer be in the back pocket of management.

Perhaps the way out for the company is an outright buyout, but this is assuming there are no other lingering financial matters within a corporation that has management that does not exactly seem to be aligned with shareholders’ interests.

I haven’t had time to do a more rigorous financial analysis on the firm, but it appears to be another oil-and-gas type company that is blowing more money out on the capital expenditure side than receiving in operating cash flow, and with the decrease of natural gas prices, those capital expenditures will have to slow down quite quickly.

Despite all of these internal struggles, the bond market appears to be somewhat calm with the credit-worthiness of the company – an example would be their bonds maturing in 2020, trading from a yield to maturity of about 6% to about 7.25% in recent times over the past three months. Preferred shares are also trading at around the 6% level, which is odd to say the least.

Q1-2012 Performance Report

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Portfolio Performance

My very unaudited portfolio performance in the first quarter of 2012, the three months ended March 31, 2012 is approximately -3%.

Portfolio Percentages

At March 31, 2012:

14% Equities
86% Cash

USD exposure as a total of the portfolio: 22%

Portfolio Commentary

A severe underperformance of the main indices – The S&P 500 was up 12% for the quarter, the TSX was up 4%. The lack of performance dealt with baggage concerning Yellow Media and other lingering items which have hence since been disposed of. The only unfortunate aspect of this is that the cheque from the government to offset the capital gains made in previous years will only be coming in April of 2013. It was a high-risk, very high reward-type bet and when you place some money on these types of ventures, you should always be prepared to take losses and that I did.

With 86% in cash, there really isn’t a heck of a lot to talk about – the 14% I do have in equity is primary in two US companies. One can be considered to be a “value” play, a company that had about two-thirds of its market cap in case, but has a business that has stable revenues and should be able to produce earnings once they learn how to cut their marketing expenses. There are growth avenues for their product line, but it should be considered a mature industry. The company has a good name brand and the target market is not going to disappear.

The other company is a growth candidate that is in a technology-related field that I am very familiar with and have done plenty of homework a few years ago on it. Only now did the stock crash sufficiently on an announcement, which I considered to be ordinary for the business but the investors obviously did not, to a valuation where it was worth picking up shares. Unfortunately I did not receive my desired fill in this or the other candidate when they were trading at relative low prices, but I will be patient and we will see. This is not a get-rich-quick stock, but it is a company that has had a very solid track record since going public of increasing revenues and earnings in a lumpy fashion – and currently these lumps have a downward trajectory.

I was aiming for an initial 10% weighting in both companies but instead got less.

While I am not that happy to see the portfolio stagnate, especially in the context of a rising broader market (fueled by the likes of Apple), I take solace in the fact that I have a mostly “blank canvas” for the portfolio and that I have not made mistakes by forcing money to be invested.

Outlook

I have been severely time constrained this quarter from researching as many investment candidates as I wanted to, but when I do have the time I continue to focus on companies that are not giving out dividends, or giving out very low dividends, both in the USA and Canada.

I remain quite cautious with respect to commodity-related companies, and I continue to be mystified with the price of natrual gas compared to oil – how long will it be before we start seeing gas to liquid energy conversion projects that will finally be able to address supply issues in the natural gas market? The easy and low-volatility play in the natural gas market continues to be Encana (TSX: ECA), but you wonder how long the supply glut is going to last? At $2.20/GJ the margins are simply not there to make huge amounts of money.

I notice industry stalwarts like Canadian Oil Sands (TSX: COS) continue to lag the market despite relatively high oil prices. They were recently able to get a 10-year bond financing out at 4.5% and 30-years for 6.0%. Plays like these all have the investor assume the underlying commodity will continue to be worth more than what the futures prices say.

The low interest rate environment continues to force people to invest in increasing marginal areas – I notice on my yield scans that almost everything with a yield is bidded up to the roof. Generally this is a great formula to generate income but generate even greater amounts of capital losses. The time to play for yield was in late 2008/early 2009 and while I am glad I cashed in on that opportunity, I realize it is not going to happen again for a long, long time.

Long-term interest rates have crept up somewhat – 10-year Canada government bonds have creeped up from the 2% floor to slightly higher. I am not sure whether this is the start of a trend toward higher long term rates or not, but something I am observing. Whenever long term rates do rise, it will create its own financial repercussions as the yielding securities I mentioned previously will inevitably look less attractive.

I remain economically cautious – zero interest rate environments create strange excesses that are quite difficult to predict how they resolve – the inflating asset prices we see today are a function of cheap financing. Regrettably this also includes most of what is available in the stock and bond markets as the thirst for yield continues. The path forward in terms of how this ends is not so clear.

Yellow Media – alive for how much longer?

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I notice that Yellow Media did not announce it was suspending interest payments on its convertible debentures (TSX: YLO.DB.A). If they would have done so it would have guaranteed them going into creditor protection.

They have about 11 months to figure out a solution to their imminent debt situation before they will go into default. The medium term notes (which are equal in level to the bank debt in seniority) trade at around 50 cents on the ask at present. The convertible debentures (junior to the MTNs and bank debt) are at about 12 cents on the dollar, while preferred shares are at about 3 cents on the dollar.

The logical investment conclusion is to buy the MTNs if you believe the entity has value after restructuring, or buy the preferred shares if you believe there will be a hugely messy process but not something that wipes out the preferred shareholders. The “middle ground” debentures will probably profit less than the preferred shareholders if there is some sort of recovery.