Category Archives: Equity

Sterling Shoes not so shiny

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Sterling Shoes (TSX: SSI) went into creditor protection today. The shares were halted at 1:27pm and the CCAA protection announcement came at 1:48pm. The TSX will delist the shares and debentures.

Investors would have had some advance warning given the announcement the company made on September 27, 2011 that they would not be able to make an interest payment on their convertible debentures. Their credit facility with the Bank of Montreal would have prevented them from making the payment.

At this point anybody that held equity in the company should have firmly jettisoned it and the company shares tanked from 37 cents the day before to about 12 cents after.

There still may be value in the debentures, although whatever slice of the company they are given in the post-restructuring is difficult to determine. The company had about $13M in secured debt and $25M in subordinated debentures. When compared to sales metrics (2010: $127M revenues, $54M gross profit) and potential profitability (i.e. there is ample room to cut SG&A by getting rid of under-performing stores), the company should be worth more than what the secured line of credit is worth – certainly, debenture holders going into the bankruptcy had not expected much, with the last trade going off at 13.5 cents on the dollar at closing.

The following is a chart of the debentures:

It is impossible for retail investors to get a fair shake at a company during a restructuring, but I do notice that Belkin Enterprises Ltd., lead by BC businessman Stuart Belkin, took a $2.573M face value stake in the Sterling Shoes debentures and announced this on September 2, 2011 on SEDAR. Was this a mis-timed investment or are they planning on participating on the subsequent recapitalization and capture value in a post re-organization stake?

I would expect such holders to get equity and warrants in the subsequent recapitalization.

A Yellow Media oddity

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Yellow Media (TSX: YLO) has all sorts of securities where investors can lose their money, but some securities are more stranger than others.

In particular, there is a prevalent oddity I have been noticing in trading of preferred shares of Yellow Media. These are the Series 3 (YLO.PR.C) and Series 5 (TSX: YLO.PR.D) series of preferred shares, which essentially are identical in all respects except for their stated dividend payout.

I will refer to Series 3 as being the “C” series and Series 5 as being the “D” series. The C series pays out $1.6875/share/year while the D series pays out $1.725/share/year. Both contain a rate reset feature, where after 5 years from initial issuance, the C series will be reset to the 5-year government bond rate plus 4.17%, while the D series will be at the 5-year government bond rate plus 4.26%. The 5-year bond is currently yielding 1.57%, but the C series will have their reset in 2014 and the D series will be in 2015.

There are also 8.1 million “C” shares outstanding, while the “D” series has 4.9 million outstanding. There is more trading volume for the C series than the D series.

Taking the midpoint of the closing bid-ask quotation, the C series is trading at $4.24 and the D series is trading at $5.15. Using some very elementary math, this translates into a yield of 39.8% and 33.5%, respectively. Obviously these very high yields are a function of the embedded risk within the underlying company’s ability to actually pay such dividends – the huge issues the business has been facing has been well publicized.

You can arbitrage the difference between the C and D series by going long 102.22 shares of C, while going short 100 shares of D. Using the quotations above, such a transaction would be income neutral and net a capital gain of approximately $81.59 per 100 shares traded.

Practically this is not possible unless if you can locate cheap shares to borrow, but investors looking at both classes of shares should clearly choose the “C” series.

Other than supply-demand dislocations because of the different number of shares outstanding of both series, I am at a loss to figure out why there is such a huge yield differential between the preferred shares. One would think the more liquid series (C) would trade at a slight premium due to liquidity. Does anybody else know?

As a disclosure, I own some of the preferred shares of Yellow Media.

Sun Life and financial insurers

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Sun Life (TSX: SLF) reported on Monday that when they report their next quarterly result, it will contain a very negative quarter. In the event of this quarter, it will be negative $621 million, operating amount negative $572 million.

By definition, financial insurance companies (such as those that provide annuities and “guaranteed income funds”) make their living by hedging. If they sell Joe Retail a product that will guarantee them 4% for the duration of the investment, the company will usually have a way of finding somebody else to give them 5% for the same period of time so they can skim the 1% in the meantime. Banks operate under the same principle, except for some strange reason they do not call it insurance.

When financial insurance companies cannot hedge properly, it will result in losses. In the event of SLF, and indeed, in the event of others such as Manulife, they have not hedged against the drop in equity markets and also the low rate environment and have been caught exposed – subsequently forced to take losses.

I have no idea whether SLF or other similar companies are under or over-valued at present. They are not easy companies to analyze and to determine where the risk is compared to the broad market.

The end of the volatility?

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Volatility (VIX) has gone under 30% for the first time since the whole mini-meltdown in August occurred.

I’m still remaining very cautious. I have not been in a very literate or concentrative mode over the past few days and thus whenever I have found myself in that situation, do not make investment decisions.

Turning point in the markets

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I hate being a chart reader, but the markets are forcing everybody to be one since nobody knows what is going on – inflation or deflation? Recession or not? Euro-default or not?

A couple prevalent charts with trend lines (very crudely drawn) indicated:

S&P 500:

10-year Treasury Bond:

Unquestionably there is a lot of concern out there with the welfare of the global economy – perhaps ECRI’s recession call was one more spike in the coffin. However, at this time, buying (or going short treasuries) is the most difficult thing to do – and a trader always knows that the best trades are the ones most difficult to do.

Sadly we are all armchair macroeconomists at this point. However, I have been compiling a “hit list” of securities that have gotten hammered over the past month and am somewhat hoping that there is another plunge down – ideally deploying cash at the time nobody else wants to. While the debt situation in Europe is hardly resolved, the potential impact of a credit freeze is being priced in with these huge and volatile price swings that go up and down.

Petrobakken finally realizing its high leverage

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Petrobakken (TSX: PBN) gave a quarterly status update with respect to its production and indeed, it is around what it stated (43,000 barrels of oil equivalent per day).

Most interestingly is the paragraphs they devoted towards recent speculation concerning their debt levels, with me bold-facing some of the quoted material below for emphasis:

At the end of September, PetroBakken had $1.14 billion drawn (essentially unchanged from the end of June 2011) on our three year, $1.35 billion credit facility, leaving us with over $200 million of credit capacity available on the current line in addition to our growing cash flow. Recently, there has been some market focus on our convertible debentures which mature in February 2016. The debentures have a one-time, one-day early put option on February 8, 2013 that allows those holders that elect to exercise the option to request payment in full for their debentures. In the event that holders request payment, PetroBakken has the option to repay in cash or through the issuance of PetroBakken shares based on the then current share price.

The Company has been, and will continue to be, pursuing various options to provide additional flexibility in order to repay any bonds that may be put back to us with either cash or shares. In addition to our growing production base and the potential for increasing cash flow over time, those options include: modifying our capital program and/or altering our dividend to provide additional free cash flow; issuing additional debt instruments; instituting a dividend reinvestment program; renegotiating the terms of the existing convertible debentures; or realizing on asset sales. Early in the second quarter of 2011, the Company engaged TD Securities Inc. as financial advisor, to assist the Company in our assessment and pursuit of certain options to provide increased liquidity, and we continue to actively evaluate alternatives going forward. Further announcements on the progress of this process will be made at the appropriate time.

We have positioned our asset base to focus on value creation for our shareholders, and decisions on how best to manage the business are made with both a short term and long term strategic outlook in mind. PetroBakken has built a strong portfolio of assets with a multi-year inventory of light oil drilling locations from which we can generate accretive, long term, growth. This portfolio includes over 440,000 net acres with over 1,400 net drilling locations in the well established Bakken and Cardium light oil resource plays; more than 480,000 net undeveloped acres and 300 light oil net drilling locations for conventional opportunities in southeast Saskatchewan; over 120,000 net undeveloped acres on new potential light oil resource plays (many that have seen significant attention by the industry in recent land sales); and a material land position in northeast British Columbia for future natural gas opportunities. With this asset base, and based on our current activity plans, we intend to deliver year-end 2011 production of 46,000 to 49,000 boepd. At the mid-point of this range, and based on US$85 WTI per barrel, we would expect to generate annualized cash flow of approximately $850 million. With expected continued growth in production in 2012, we would anticipate funds flow from operations (based on a similar WTI price) to grow further to equal or exceed our total capital expenditures and dividend payments. However, if conditions change, we will not hesitate to evaluate the other alternatives available to us, including altering our dividend and/or capital spending levels.

Current economic conditions and market rumours have caused shareholder focus to be turned away from the high quality, light oil assets that underpin the Company, to the perceived strength of our balance sheet in light of the convertible debenture put date (that is 16 months away) and our current capital and dividend plans. We are aware of the concern over our debt position and, as outlined above, we have several options at our disposal which we are actively assessing to effectively manage this situation in varying commodity price environments while continuing to pursue our strategies for long term, accretive, growth.

Some notes that went through my head:

1. The company’s current market capitalization is CAD$1.26 billion; the amount of the convertible note is US$750M. At present prices a share conversion would result in a 38% dilution of shareholder interest in the company. In addition, the additional amount of shares would virtually guarantee a dividend decrease (the convertible note’s coupon is 3.125%).

2. How much in capital expenditures does it take to sustain a production level at 43,000 boepd, or even to expand it to 46,000-49,000 boepd? If the company decided to pare back capital expenditures, how fast would production decrease? The large problem with the wells the company is producing is that the majority of oil obtained comes from the first year – production tapers off rapidly from the initial production.

3. Is WTIC at US$85 a valid assumption? Obviously this is something the company can’t control but is an obvious factor in the market price. At 47,500 boepd, WTIC at US$85 for CAD$850M operating cash flow will drop significantly as WTIC goes lower (more than a CAD$10M decrease to a US$1 drop in WTIC!). The operating cash flow is ultimately an incomplete figure since it goes back to question #2 where you have to ask yourself how much in capital expenditures will it take to actually keep production at that level. However, they do have 8000 boepd (roughly 17% of expected production) hedged with an average floor of US$76.09 WTIC in the year 2012. This still will not protect them from more significant decreases in oil prices.

I still believe Petrobakken equity is trading above fair value. They will be going through a painful de-leveraging as they figure out how to cough up US$750 million in 16 months.

Petrobakken – plunging down

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While I have been losing a small amount of money on Yellow Media’s preferred shares jaunt to zero, fortunately I have steered far away from Petrobakken (TSX: PBN) which I have written here many times before.

They will not have an easy time renewing their credit facility which expires on June 3, 2012. The debtors are clearly in control of this one, just like how they are in control of Yellow Media. There is $1.14 billion in bank debt at the June 30, 2011 quarterly report. Another looming timeline is a US$750M debenture which holders have a put right – they give notice in December 2012 and the company must redeem at February 8, 2013.

(Update, September 29, 2011: Apparently they managed to renew their credit facility with an extra $150M in the facility… oops! This was announced in their Q2 financial update, which completely escaped me – this kind of blows a hole in the immediacy of cutting the dividend in the subsequent analysis, but there still remains a significant debt renewal of US$750M that will be taking place in February 2013).

From the MD&A, August 9, 2011:

As at June 30, 2011, PetroBakken had $1.14 billion of bank debt drawn on our $1.35 billion credit facility. Our credit facility is with a syndicate of banks and has a maturity date of June 2, 2014. The amount of the facility is based on, among other things, reserves, results from operations, current and forecasted commodity prices and the current economic environment. The credit facility provides that advances may be made by way of direct advances, banker’s acceptances, or standby letters of credit/guarantees. Direct advances bear interest at the bank’s prime lending rate plus an applicable margin for Canadian dollar advances, and at the bank’s US base rate plus an applicable margin for US dollar advances. The applicable margin charged by the bank is based on a sliding scale ratio of PetroBakken’s debt to earnings before interest, taxes, depletion, depreciation and amortization (“EBITDA”). The facility is secured by a $2.0 billion demand debenture and a securities pledge on the Company’s assets. The credit facility has financial covenants that limit the ratio of secured debt to EBITDA to 3:1, limit the ratio of total debt (total debt defined as facility debt plus the value of outstanding debentures in Canadian dollars) to EBITDA to 4:1, and limit secured debt to 50% of total liabilities plus total equity. The Company is in compliance with all of these covenants.

The TTM EBITDA is $659M, thus they are comfortably in compliance with this ratio. You would think the banks would be slightly uncomfortable with lending this much money in a company that is so heavy on capital expenditures.

My immediate guess is that the company will have to seriously curtail, if not outright suspend their dividend until such a time they are able to repay a substantial portion of their credit facility. This is not news to me – I had predicted this in May of 2011.

Another course of action they will likely implement is a slowdown of their capital expenditures. The only consequence of this, however, is that they will not be able to keep up their production levels, which their wells strongly taper off after the first year of drilling. This in turn will hinder their financial results.

The company is also highly sensitive to the price of oil and the past six months of WTIC trading has not helped their cause any.

Even though PBN has been sent down over 50% over the past couple months, it is still trading above my fair value.

Got my hands bloodied up catching Yellow Media

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As I alluded to in an earlier post, catching plunging knives (in this case, catching plunging share prices) will leave your hands bloodied, and indeed this has been the case with Yellow Media.

They announced this morning that they will be suspending their common share dividend and also will be reducing the size of their credit facility to $500M, of which $250M will be paid off at $25M/year from the beginning of 2012 onwards.

This caused their common stock to plummet, but oddly enough, caused their preferred shares to drop equivalently, to the tune of 50%.

PR.C shares are down to $3/share, while PR.D shares are down to $3.08/share.

By slashing the common dividend, they will save about $77M/year in cash flow.

With the common share dividend gone, it will remain an interesting decision whether the company will decide to cut preferred share dividends. PR.A will cost the company $10.7M/year, but this will be alleviated when they convert them to shares in April 2012. PR.B will cost $7.6M/year, but this will also be alleviated when the company force converts them in July 2012.

PR.C is the next drain on cashflow – $13.2M/year, and PR.D is $8.5M/year. Both of these series are cumulative and can only be called by the company at par ($25) which is obviously not going to be happening with them trading at $3 over the open market.

The debentures are trading at 32 cents and represents a $13M/year interest expense for the company – these interest payments must be maintained otherwise it will constitute a default – a 20% current yield, but how long will you see those coupon payments being paid?

The real question is: how quickly is the company’s cash flow diminishing? This “decay rate” is the critical variable in determining how financially viable the company is going forward.

The company’s preferred shares are obviously a very high risk and high reward type situation if your assumption is that they are not going bankrupt and they will be able to level off their cash flows at a positive amount.

Berkshire and commodities

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Two observations – Berkshire announced that it will repurchase its own shares at no more than a 10% premium to book value. The stock went up about 8% in trading during the session to roughly this level. Book value is $163 billion, while the company has 1.649 million class “A” equivalent outstanding for a book value of about $98,850 per share. Add 10% and this gives a value of roughly $108,700 per share, not too far from the closing price.

I find this interesting simply because Warren Buffett is now a net seller of his own company and he is quite good at using his mouth to talk up or down the market when it suits his purposes – there tends to be a media aura that he is relatively altruistic. I am not convinced that Berkshire makes a compelling value as its analysis is not that easy – essentially an insurance operation with a series of fully-consolidated subsidiaries and a hodge-podge smattering of equity in various well-known companies (including Burlington Northern). When at the scale of Berkshire, the rules of engagement are considerably different since it takes forever to build and exit positions – not as easy as plugging in a market order to buy 100 shares of Microsoft.

The last time Buffett talked about buying back his own shares was when it was trading at $40,000 at the peak of the tech bubble. He graciously offered anybody that was willing to sell at that price can call him up and sell it to him at the prevailing bid on the NYSE at the time. Nobody took him up on that offer.

The other observation is commodity prices appear to have developed a “spike” on the charts. Observe the following:

Although I am hardly a technical trader, my best guess at this time is that the three commodities will head up for the rest of the week or so before declining again and “retesting” the bottom of that spike and likely trending down. There was clearly some sort of liquidation that has been occurring and the market is not that deep.

Bloody hands catching the Yellow Media falling knife

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With the recent plunge of all securities of Yellow Media (TSX: YLO) I have decided to get my feet wet in purchasing a small mixture of the C, D preferreds and some convertible debentures.

Suffice to say, this is not a low risk investment. These securities are trading as if very, very, very bad things are going to be happening to the company, if not outright bankruptcy. The winning condition for an investor at these prices is that the company does not declare bankruptcy in the medium term future.

The business story is quite well known. The company is in the throes of a massive reorganization from print to digital and this has created tremendous risk.

The solvency of the company will be tested around the 2013 timeframe, when they face maturities of some of their Medium Term Notes and their credit facility. The upcoming maturities of the Medium Term Notes between 2013 and 2016 are the following (noting the values are as of December 31, 2010 – the company has repurchased some of these notes):

- $130 million of 6.50% Series 9 Notes maturing on July 10, 2013 priced at par, for an initial yield to the noteholders of 6.50% compounded semi-annually
- $125 million of 6.85% Series 8 Notes maturing on December 3, 2013 priced at par, for an initial yield to the noteholders of 6.85% compounded semi-annually
- $297.5 million of 5.71% Series 2 Notes maturing on April 21, 2014 priced at $99.985, for an initial yield to the noteholders of 5.71% compounded semi-annually
- $260 million of 7.3% Series 7 Notes maturing on February 2, 2015 priced at par, for an initial yield to the noteholders of 7.3% compounded semi-annually
- $387.4 million of 5.25% Series 4 Notes maturing on February 15, 2016 priced at $99.571, for an initial yield to the noteholders of 5.31% compounded semi-annually

Yellow Media Inc. has in place a senior unsecured credit facility consisting of:
- a $750 million revolving tranche maturing in February 18, 2013; and
- a $250 million non-revolving tranche maturing in February 18, 2013.

Notably, the credit facility has a covenant of a minimum ratio of Latest Twelve Month EBITDA before conversion and rebranding costs to cash interest expense on total debt of 3.5 times. Obviously if the financial performance of the company continues to dwindle they will be compelled to pay this off before the MTN’s. They have $636M outstanding on June 30, 2011 in these facilities.

The difference in capital structure between the preferred series and the convertible debentures is relatively minor – the debentures are $200M of face value (maturing October 2017) which have priority over the preferred shares. The higher price paid for the seniority is reflected in the fact that an investor is likely to continue receiving coupon payments (until if/when the company defaults on its more senior debt).

Finally, with the sale of Trader Corporation and the net proceeds of approximately $700M, the company will have further financial flexibility to maneuver around its credit facility covenants and be in a position to use its cash to repurchase debt. At current prices, such repurchases will be highly yielding – for example, if the company did a dutch auction tender for its convertible debentures at 40 cents a piece, every million dollars tendered would save the company from $162,500 of pre-tax interest payments.

The other trading note is that the PR.C series of shares has a slightly lower coupon than the PR.D series (6.75% vs. 6.9%), but the PR.D has typically traded at or lower than PR.C prices. There may be a liquidity premium as there are more PR.C shares outstanding. In addition, spreads are quite high until the computer algorithms put in very small bid and asks and since other algorithms are hammering the bid this tends to create quite a bit of price gapping. The last trading note is that every fund manager on the planet will be embarrassed to show these securities in their quarterly statements, so the “window dressing effect” will likely mean that they will be jettisoning their securities before the September 30th date (3 days for trade settlement means they will be getting rid of them by early next week). Since there is a lack of liquidity in the preferred series, this has resulted in dramatic price drops.

I anticipate the common shareholders are not going to be too happy when their dividend will get severely cut again and diluted by the preferred share conversions. However, the company will have to take these drastic steps to save itself and to de-leverage. Deleveraging is always a very, very painful process when it is forced.

I highly suspect that an opportune time to catch the falling knife is very close. Stocks are most volatile at their highest and lowest points and this appears to be a low frenzy. Time to get my hands bloody.