Category Archives: Debt

For risk-takers only: Priszm Income Fund

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The most troubled (but not formally bankrupt… yet!) company trading on the TSX is the Priszm Income Fund (TSX: QSR.UN), which operates fast food franchises. The fund owns 60% of a limited partnership that operates 432 restaurants (KFC, Taco Bell and Pizza Hut) across seven Canadian provinces. The other 40% is owned by a corporation controlled by the fund manager.

Unfortunately for the fund, they have substantial balance sheet issues. As of September 5, 2010, they have a $66 million loan that is secured by substantively all assets of the company, and this loan is due at December 31, 2010 (which was not paid). The company had $13.4 million in cash in early September, and cash through operations in the first 9 months of 2010 generated approximately $3.4 million. It should be noted the business is seasonal, with most of the revenues obtained in the third quarter (summer) season.

The company is trying to liquidate over half (232) of their restaurants, all located in BC and Ontario, for $46 million (link) but this deal has not closed yet. Even then, the company is not quite out of the woods in terms of their balance sheet situation.

Notably, the company has $30 million in unsecured convertible debentures outstanding that are due on June 30, 2012. The company has not paid interest on them at the end of December 31, 2010.

The debentures are trading at around 20 cents on the dollar, and have tanked over the past month as the solvency issue became very apparent:

This is a lesson for debenture investors that market valuations can be considerably divergent from the underlying truth – as early as the beginning of December, debentures were worth about 70 cents on the dollar – any investors at that point would have received a 70% haircut in valuation AND also the ignominy of paying the sellers 5 months of accrued interest!

It is also not quite clear even if the fund can realize $46 million in value out of the 232 franchises whether they will be able to avoid bankruptcy – they still have a considerable amount payable after this liquidation. Such a liquidation would occur on January 15, 2011 if approved by the buyer after they do their due diligence.

That said, it makes one wonder whether there is still value in the convertible debentures of Priszm. They are very cheap, but very cheap for a reason – even if the company can liquidate their franchises for an acceptable price, there is a stack of other payables that are due, possibly before or possibly jointly with unsecured debenture holders. Study up on your knowledge of the Bankruptcy and Insolvency Act! Suffice to say, this one would be for extreme risk-takers only.

Disclosure – No positions.

Corporate Debenture Screen for TFSA

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Since a good deal of investors put their federally mandated $5,000 into the Tax Free Savings Account at the beginning of the year, the next logical question is what to invest it in.

A 1-year GIC, at best, can yield you about 1.75%. Other banks give you teaser rates, roughly around 2% for a floating rate. So naturally the eyes waver to more riskier options, mainly the corporate debt market.

The following is an exhaustive list of TSX-traded debentures that are scheduled to mature by December 31, 2011:

Maturity Ticker Coupon Price Conv. Price Share Price ITM
1-Jan-2011 NPF.DB.A 7.00% 75 6.9 0.39 5.7%
30-Apr-2011 PVE.DB.D 6.50% 101.01 14.75 8 54.2%
31-May-2011 PWT.DB.E 7.20% 101.8 75 24.5 32.7%
30-Jun-2011 KEY.DB 6.75% 302 12 34.96 291.3%
30-Jun-2011 NPI.DB 6.50% 126.04 12.5 15.79 126.3%
31-Jul-2011 AG.DB 6.50% 84.5 12.6 1.12 8.9%
15-Aug-2011 WEQ.DB 9.00% 105 4.2 4.5 107.1%
16-Aug-2011 WEQ.DB.B 8.50% 101 5.25 4.5 85.7%
30-Sep-2011 PRQ.DB.A 6.25% 102.01 24 12.5 52.1%
1-Dec-2011 AAV.DB.D 7.75% 102 21 6.81 32.4%
31-Dec-2011 GCL.DB 7.00% 121.6 10.25 12.06 117.7%
31-Dec-2011 EQU.DB 8.00% 102.5 27.75 6 21.6%
31-Dec-2011 FEL.DB 6.50% 102.5 13.5 4.34 32.1%
31-Dec-2011 FBK.DB 7.00% 100.2 4.32 1.15 26.6%
31-Dec-2011 IRG.DB 7.75% 100.1 10 2.4 24.0%
31-Dec-2011 LRT.DB.G 7.50% 77 7 0.4 5.7%
31-Dec-2011 PWT.DB.F 6.50% 102.75 51.55 24.5 47.5%
31-Dec-2011 UUU.DB 4.25% 98.75 15.76 4.77 30.3%
31-Dec-2011 WRK.DB.E 6.30% 102 20.63 20.17 97.8%

The last column gives you an indication of how much the embedded call option is a factor in the underlying bond pricing – KEY.DB is well within the money, while NPI.DB, WEQ.DB, WEQ.B.DB, GCL.DB and WRK.E.DB are roughly at the money.  For all of these issues, the debenture then becomes a strong exercise in equity valuation rather than debt valuation, which involves a whole different type of analysis to properly perform.

The rest of the candidates leave a lot to be desired; the high yielding candidates appear to be Fibrek (FBK.DB) and Imvescor (IRG.DB) but both of these companies appear to have issues that would not exactly make them low risk candidates.  Fibrek used to be known as SFK Pulp, and people that remember SFK should know about their chronic debt problems – although they have made good strides since the beginning of the year in reducing their debt, there is still $85 million of first-order debt that is in front of the $50M convertible debentures.  It is likely they will be able to roll-over the debt, but not a slam dunk by any measure.

It should be pointed out that the pulp and paper industry has had a major cyclical turnaround and Fibrek appears to be greatly benefiting from it at present.  Contrarian investors made a killing if they invested in the middle of 2009; the equity is up from roughly 20 cents to $1.15 presently, but it should also be noted that in the middle of 2009, a bankruptcy liquidation was a very real possibility.

Imvescor is a restaurant and franchising company that can only be described as a mess – they also have $45M in other debt that ranks ahead of the $22M of convertible debentures.  I have not spent much time analyzing this company other than to briefly gloss over its financials.

If you split your money between both of them and were able to cash out at maturity, you’d be looking at around 7.2% yield to maturity, which doesn’t seem like a lot of compensation for a year’s worth of risk in these less than ideal investment candidates.  One has to dig deeper into the markets to find acceptable risk/reward in both the tax sheltered and non-registered accounts.

Maturity Ticker Coupon Price Conv. Price Share Price ITM
January 1, 2011 NPF.DB.A 7.00% 75 6.9 0.39 5.7%
April 30, 2011 PVE.DB.D 6.50% 101.01 14.75 8 54.2%
May 31, 2011 PWT.DB.E 7.20% 101.8 75 24.5 32.7%
June 30, 2011 KEY.DB 6.75% 302 12 34.96 291.3%
June 30, 2011 NPI.DB 6.50% 126.04 12.5 15.79 126.3%
July 31, 2011 AG.DB 6.50% 84.5 12.6 1.12 8.9%
August 15, 2011 WEQ.DB 9.00% 105 4.2 4.5 107.1%
August 16, 2011 WEQ.DB.B 8.50% 101 5.25 4.5 85.7%
September 30, 2011 PRQ.DB.A 6.25% 102.01 24 12.5 52.1%
December 1, 2011 AAV.DB.D 7.75% 102 21 6.81 32.4%
December 31, 2011 GCL.DB 7.00% 121.6 10.25 12.06 117.7%
December 31, 2011 EQU.DB 8.00% 102.5 27.75 6 21.6%
December 31, 2011 FEL.DB 6.50% 102.5 13.5 4.34 32.1%
December 31, 2011 FBK.DB 7.00% 100.2 4.32 1.15 26.6%
December 31, 2011 IRG.DB 7.75% 100.1 10 2.4 24.0%
December 31, 2011 LRT.DB.G 7.50% 77 7 0.4 5.7%
December 31, 2011 PWT.DB.F 6.50% 102.75 51.55 24.5 47.5%
December 31, 2011 UUU.DB 4.25% 98.75 15.76 4.77 30.3%
December 31, 2011 WRK.DB.E 6.30% 102 20.63 20.17 97.8%

Holloway Lodging REIT vs. George Armoyan

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I note with interest that Holloway Lodging REIT (TSX: HLR.UN) has finally received a notice from Royal Host REIT (TSX: RYL.UN) that they want to kick out the three independent trustees and replace them with people of their choosing. Royal Host REIT owns about 7.4 million shares of Holloway, which is about 18.9% of the equity.

Royal Host REIT is chaired by George Armoyan, an east coast Canadian that has various financial interests and is similar to a small-scale Carl Icahn. Armoyan, in addition to being the chairman of Royal Host REIT, former chair of Clarke (TSX: CKI), runs his private corporation Geosam Investments. He has a very interesting history of taking minority stakes of companies, enough to control the board, and then convert the operations into more profitable ones. While his record is not 100% by any means, he does generally have a track record of success mixed in with a few failures.

Holloway Lodging REIT can be classified as a broken income trust – having gone public in the middle of 2006 during the boom in income trust issuance (just before the federal government shut the door on trusts), their equity has more or less gone on a straight downward trajectory and now trades at about 28 cents a unit. At 39.1 million units outstanding, the trust has a market capitalization of $10.9 million. The company’s current operations involving owning and operating 22 hotels, which consist of 2,386 rooms. About 60% of the hotel rooms are in Alberta. You can also dig into their financials and see that management has been wheeling and dealing with related entities (Pacrim Hospitality) and has lost money on various failed joint ventures (Windham, Winport).

Not helping their business is that capacity has been growing in their target markets (which generally consist of Super 8-type motels in back-country areas like Grand Prairie, High Level, Fort Nelson, etc.) which has lead to price competition and a drop in booking amounts. The company’s operations on the eastern side of the country, however, have not been that bad. When you look at the bottom line statement, the company is barely operating cash flow positive – about $2.3 million for the first 9 months. The last 3 months of the year will likely be a net loss. When capital projects and other miscellaneous items are factored in, it is pretty clear that this company is not financially on strong ground.

On the balance sheet side is where things are interesting, and I am using September 30, 2010 figures. The cost basis of the various capital investments the corporation has made is $367 million (mainly buildings for $297 million), offset by $44 million in accumulated amortization. Thus, the book value of $323 million in assets is something to be considered, even if the market value of these assets are to be impaired further than what the stated carrying value is.

On the liability side, it is much more ugly – the company is $1 million into its $5 million line of credit, and has $154 million in first-line mortgages (with a blended rate of 6.81%). $1.3 million of this is due by year-end, $7.4 million of this is current (i.e. due by September 30, 2011) and $30.5 million is due by the end of 2011.

Finally, the company has two convertible debenture offerings outstanding. The first is a $20.2 million offering, 8% coupon, that matures on August 1, 2011. The second is a $52 million offering, 6.5% coupon, that matures on June 30, 2012.

Suffice to say, the company has no way of paying off the prinicpal of the convertible debentures without performing a wholesale asset liquidation. While they may be able to refinance the mortgage, using the building and property as security, they will have a very difficult time refinancing the debentures without raising cash.

The 2011 debenture trades at bid/ask 92/93 and the 2012 debenture trades at 51/55. Yield to maturity is an irrelevant calculation in this case – what matters is capitalization. Using midpoints for both of them, the debentures have a combined market value of $46 million.

The math for a potential investor, is simple. If you assume you can actually liquidate the assets at the stated carrying value, and use the proceeds to pay off the mortgage and convertible debentures, you are left with approximately $117 million (i.e. this is the amount of unitholders’ equity). This is considerably above the current $10.9 million market capitalization.

The market realizes that things are not this simple. For example, if you assume that the carrying value of the property assets are actually 30% lower than what is stated on the balance sheet, suddenly your $117 million has shrunk into $20 million take-home. Still, this is not a bad haul if you just paid $11 million for the company.

When you factor in the price of the debentures, and price the equity at zero, the market is implicitly assuming that the property and land is equal to about 65% of its carrying value. The question for an investor is whether this should be lower (in this case, sell the debentures) or higher (in this case, buy the debentures). This assumes that the operations of the company are cash-neutral.

Obviously George Armoyan is taking enough of an interest in Holloway’s assets that he is spending time and energy on this little project. His own REIT, Royal Host, is not exactly a financial superstar in its own right, but there are obvious administrative synergies to be obtained if it were to merge together with Holloway. The only downside is that there would have to be a mandatory offer to redeem the debentures at par – something that skittish debenture holders would likely waive if the debt were to be backed with a stronger partner than the existing management at Holloway, which has been proven to be a dismal failure.

It is likely management is going to spend time and energy, and more importantly, money to try to fight this battle. Hence, the debentures dropped from a quote of 60/61 to 51/55 when the news came out – normally a battle for the board would usually stimulate prices because somebody is actually interested in taking an economic interest in the company, more so than existing management.

The reason why I am taking an interest in what is otherwise a fairly obscure sector of the business world is because I have a position in Holloway Lodging’s June 2012 debentures. I bought them in the first half of 2009 during the economic crisis, and it was one of the worst binary decisions I made – although if I liquidated today I am still nominally up on the investment, my other option that I was contemplating at that time was InnVest series B debentures, which is now a “lock” for a maturity at par.

Watch the long term rates, and a portfolio update

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Long-term rates are creeping up slowly – it is difficult to tell whether the increases in 30-year bond yields over the past couple months will be part of a longer-term trend, but I believe this will be the case as people become leery of lending money to the government for the long haul.

I will have more to write about this in my year-end report.

Finally, I have been slowly deploying some cash, specifically in the oil and gas sector. I had identified an opportunity back in September, and set some orders slightly below market but they were not filled. It was frustrating to see that company trade above, and indeed it is about 25-30% above where I had originally wanted to purchase it. C’est la vie.

More recently, there were a couple low-volatility equity opportunities in the oil and gas sector that I believe are trading at the low band of their fair value range. One in particular seemed fairly attractive and appeared to have their “yield premium” excised from them. As readers here know, I have been seeing many companies that have their equity overpriced because of the market paying a significant premium for yield, and it is important when shopping for stocks that you do not pay this premium.

Conversely, it seems that there may be a discount for companies paying zero dividends or low dividends (other than well known issuers such as Apple and Amazon!), so I have been paying attention to the zero-or-low yield equity market. I am just as happy to take money in the form of capital gains rather than dividends.

On the fixed income side, I have not seen anything attractive. The fixed income market has been drier than a summer afternoon in the Las Vegas desert. I could string together a short-duration low-risk portfolio of debentures that will yield a pre-tax yield of approximately 6%, but there would be zero opportunity for capital appreciation. The only other speculative opportunity I saw earlier was in First Uranium notes, but even this has been priced to a market-efficient level given its high risk nature.

It is not the most pleasant of times if you are forced to deploy cash at present. Patience, and the ability to keep your cash for a better time, is the name of the game.

First Uranium – valuation

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I don’t know why I find the trading of First Uranium (TSX: FIU) to be this exciting, but it is fairly obvious the market is pricing in a turnaround in its operations. Considering that it couldn’t have been managed worse in the year 2009, this is not entirely surprising. FIU shares are up about 60% over the past month. A share price of $1.25 gives it a capitalization of $220 million. The shares will start to face resistance as it cuts into the overhang caused by the secured note issue (which is a $150M issue with a $1.30/share conversion price). Conversion of the notes will result in about 115M shares issued, or about 40% of the company.

Valuing the notes, subordinated debentures and equity is not a trivial process.

The notes currently are not the most liquid product on the planet, with a closing bid/ask of 105/124 cents on the dollar. These notes are also secured by assets and in the event of a default would likely have some sort of recovery. Using the flawed Black-Scholes model, and using a 50% implied volatility (which is an incorrect estimate) gives a 36.5 cent per share value per call option at $1.30, expiring in March 2013. At 105, ignoring the conversion feature of the note, represents a 6.7% current yield and a -2.0% capital loss for the remainder of the 2.4 year term. The actual return realized by noteholders will depend on FIU’s trading price.

Using the 50% implied volatility figure, the option embedded within the notes have a “delta” of about 65%, which means that for every 1% that the equity changes, the underlying value in the conversion feature will change 0.65%. If FIU trades significantly above $1.30/share, the equity portion will dominate the value of the note, while if FIU trades under $1.30, other considerations such as ability to liquidate the assets become more of a consideration. There is no “clean” way of valuing these notes, as you have to separately calculate the fixed income and equity components, despite the fact that both of them are linked!

The unsecured debentures, maturing on June 30, 2012 are trading bid/ask 75/77, and using the midpoint as a reference, the yield to maturity is a whopping 23.0%; or the current yield is 5.6% and capital gain on maturity at par is 18.7%, for a joint yield of about 24.3%. It is likely that if FIU is trading significantly above $1.30 around the maturity date of the debentures that they will be able to refinance them. If FIU is trading under this, then it becomes increasingly likely that the debentures will receiving significantly less – the people holding the debentures can force a bankruptcy, but given their low seniority they will likely not be in much of a position to doing so.

The equity has traded historically as high as $8/share in May of 2009, and the company was very smart to pull off an equity offering near this price (before the shares tanked). Indeed, if this valuation was at all correct, even when you factor in the subsequent dilution, there is the potential to see the operation go for $3-$4/share if everything goes to “plan”. Of course, it has not in the past, and will likely have issues in the future!

FIU’s capital structure is a very strange one to analyze, especially with respect to the profitability of its operations. As I stated before, this is a classic high risk, high reward situation. In no way would anybody be sane to “bet the farm” on it, but a small allocation is in order – which is what I have at present in both the notes and debentures but not the equity. The notes already have enough equity value in them that can take direct advantage of a price rise in equity.

Thirst for yield – FortisBC

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Via James Hymas’ daily report…

FortisBC (a subsidiary of Fortis, TSE:FTS) sold CDN$100 million worth of the most mis-named “Medium Term Notes” which, according to the shelf prospectus filing, are unsecured debentures. The yield was 5.01%, a spread of 135bps over government, and the term was… 40 years.

I know utility companies are supposed to be rock-solid stable, but this thirst for yield is becoming a bit too much to handle. Capital is racing to purchase income at any cost. Equity in the master company (Fortis Inc.) at current prices and past 12 months of earnings ($1.60 EPS) is 5.1%, so assuming any sort of natural growth for inflation and rising prices would lead one to suspect that the equity would be the cheaper option, even when you factor the elevated prices for utility company equity. Fortis’ common shares hardly budged even during the peak of the late 2008-early 2009 economic crisis.

Unloading some more long term debt

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One of my corporate long-term debt holdings in R.R. Donnelley (NYSE: RRD) has been trading significantly higher since my purchase point in 2009. I had invested in the 6.625% October 2029 debenture, via a trust preferred security (NYSE: PYS), which has a coupon of 6.3%.

Although I had been sitting on large unrealized gains on the issue and was intending to dispose of it in 2011, the trading above 24 proved to be too tempting so I unloaded it and realized gains. Although it’s entirely possible the bonds will continue trading this high in a couple months, I didn’t want to take the gamble.

Mathematically, assuming a continuous yield (which the trust preferreds do not trade as; they trade “as-is”), the PYS security would have a pre-tax current yield of 6.5% and an implied capital gain over 18.9 years of 0.2%. This is below what you can get with some shorter duration fixed income securities, so disposing of this will be a good decision assuming I can deploy capital more efficiently in the future.

The equity in RR Donnelley at this moment appears to look like a better investment than its long-term debt – the company’s cash generation is significant and its debt is termed out properly and has been managed well, so there is unlikely to be a liquidity risk with the operation. Even if you assume they do absolutely nothing but earn income at the rate they have been doing in the past 9 months (a false assumption due to seasonality in their business), the equity will be yielding a minimum of 7.6% at present prices – a compensation of about 1% over debt. When you factor some very conservative growth assumptions, it skews significantly in favour toward the equity relative to the debt.

In terms of overall portfolio movement, my long-term debt holdings have shrunk again and cash has increased. If/when long-term government bond yields start to rise this should prove to be a good move.

Clearwater Seafoods debenture refinancing

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This is slightly old news, but on October 7, 2010 the management of Clearwater Seafoods Income Fund are trying to get $45 million in debentures, due at the end of the year, out of the way without excessive cost.

The terms they offered are the following:

- Higher Interest rate: The proposed amendments provide Debentureholders with an interest rate that will be increased by 3.5% from 7.0% to 10.5%.
- Lower Conversion Price: The conversion price will be reduced from $12.25 per Fund unit (“Fund Unit”) to $3.25 per Fund Unit.
- Extended Term: The maturity date will be extended from December 31, 2010 to December 31, 2013, and the amended debentures will not be redeemable prior to June 30, 2011. As such, Debentureholders will have a longer period of time to receive a higher interest rate and potential to exchange their debenture for equity in an entity that is poised to create significant value for unitholders.

The higher interest rate is the only appealing sweetener for the holders – the conversion price decrease is insignificant when compared to the present unit price of 86 cents per unit; the extension of the maturity is also not beneficial when considering that it puts them behind in order with a series of term loans and a bond maturing on August 2013.

If I was holding the debentures (which I am not), I would walk away this deal.

If they dropped the conversion price to $1.00/unit, I would consider it. $3.25/unit, however, is a ridiculously high conversion rate.

Even if the debenture holders were stupid enough to approve this deal, they will not be collecting their coupons for too long since the company actually has to generate cash to pay out. It will not be long before this whole company has to give out a lot of equity to get rid of the high debt on their books. It would be one thing if the company were operationally running well but was financially leveraged too highly, but it just appears that this company is not particularly profitable, but management talks like it is.

When management has to use language like “potential to exchange their debenture for equity in an entity that is poised to create significant value for unitholders” in a pitch to debt holders, I have my doubts the right people are running the company as they are taking their owners and creditors like idiots.

The public will find out on November 12, 2010 whether this proposal goes through or not.

As I have previously disclosed, I have no holdings in Clearwater Seafoods equity or debt.

Get ready for the next soverign debt crisis

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It appears that Ireland’s ability to borrow money is becoming much more impaired in the past three months, looking at the 10-year yield on their notes (note that the chart is the spread between the German and Irish 10-year sovereign debt, not the absolute yield to maturity of the Irish 10-year note; Germany’s 10-year debt yields roughly 2.4% at present):

The absolute yield to maturity is here:

Observers should note that during the Greek bond crisis (which peaked in early May 2010) that yield spreads on the same Irish notes went up from roughly 1.3% to 3.0% before trading at a range of roughly 1.6% to 4.5% before this wave of relative selling hit. This corresponds to a yield to maturity on Irish debt of roughly 4.4% to 5.9% and 4.6% to 6.7% after the Greek debt crisis.

Something else to note was that US treasuries were recipients of capital inflows during the Greek debt crisis, which apparently is not happening right now.

I have no further insight other than what is making the news right now, which means it is not tradable information. But it is something to be aware of – there may be another European sovereign debt crisis coming down the pipeline. If a yield spike hit the US government debt market, it would make major financial headlines. There is no telling whether the 50 basis point run-up in the last month is the start of a 5% rise in yield, or whether it is market noise.

Rising bond yields

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The chart of the 30-year treasury bond clearly shows an increasing yield since roughly early October:

Yield is up from roughly 3.65% to 4.25% presently. Will this trend continue? It seems the market is starting to price in long-run inflation, especially when contrasted with the 10-year yield:

Yields from early October is up from 2.50% to 2.66% presently.

It is very difficult to trade a bond market when the environment is so explicitly manipulated by large players (the Federal Reserve being one) – there is a lot of money to be made predicting their next move, but from the retail end it is very difficult to judge since there are a lot more informed participants in the bond market.

One consequence of increasing bond rates is that the price of obtaining long term corporate debt will rise. On the 10-year the rise doesn’t appear to be much above ambient noise levels, but there is clearly something going on in the 30-year.

Historically, however, 10-year yields are trading at relative lows.