Long-term treasury yields

Bill Ackman has made the news about being short 30-year treasury bonds (buying puts on treasuries). You can play this trade at home too, by buying puts on TLT – at the money on long-dated options is trading at an implied volatility of about 16.5% right now. The below chart is the 30-year treasury bond yield.

There have been other prominent people in the Twittersphere piling in (e.g. Harris Kupperman) on the risks of long-term interest rates rising – it’s one way to flatten the yield curve with the short side going longer, it’s another thing completely for the long end of the curve to go up.

In general, when more people are conscious of a particular direction of trade, the riskier the trade becomes. Both Ackman and Kupperman are “talking their book” at this point, the question is whether they were at the beginning of this wave, or whether it’s mid-crest. I’m not sure.

My lead suspicion from a macro perspective is that the market is catching wind that the US Federal Reserve is not going to let up on short term interest rates anytime soon, coupled with the US Government’s Treasury issuing tons and tons of debt financing after Congress approved the rise in the debt ceiling – the US Government is raising a huge amount of cash. Economic data is too strong and employment is surprisingly resilient (with resultant wage pressures). We still see way too much speculative impulses in the market (for a good time, look at American Superconductor – AMSC on the Nasdaq).

What you’re seeing as a result of slow quantitative tightening, the US Government being the first claim on US currency (the treasury auction IS the price on money), and continually rising interest rates is a liquidity drain. As the liquidity gets sucked out of the system, the continual demand for money (the least of which to pay interest on debts) will result in a higher cost of money until the Federal Reserve decides to stop. Because so many have speculated about “the pause”, it blunts the effect of rising interest rates and hence the need to raise rates and tighten liquidity further.

Let’s take the Kupperman scenario of long-term rates going to 600bps, which means a risk-free P/E of 16.7 for significant duration. I’ve pointed out in the past that the risk-free rate is competing significantly against equities and this competition gap will continue to get wider and wider. We would surely see equities without earnings power depreciate. We would also see higher incumbency advantages in capital-intensive existing companies. I also think it would be the straw breaking the camel’s back with certain REITs which are already on the financing bubble (look at my previous post about Slate Office).

The question is whether the US Government, currently printing off massive deficits, would actually be able to taper their spending or whether this leads to another conclusion that we’re going to see massive levels of inflation, much more so than we previously have seen. Will we get to the point where we see defaults and a credit crunch?

Either way, it leads to a similar conclusion – keep a bunch of dry powder (cash) handy for buying into blow-ups that won’t go into Chapter 11 or CCAA. The 5.5% or so of short-term risk-free money is better than nothing, although I too even think this is a crowded trade. For large-cap investors out there, an example of an opportunistic miniature blowup was TransCanada (TSX: TRP) a few days back – although something makes me suspect you’re going to see it go even lower than $44/share in the upcoming months. There are going to be plenty of further examples like this going into the future of companies facing issues with debt.

Looking at the Slate Office REIT train wreck

Today’s victim is Slate Office REIT (TSX: SOT.UN). I’ve written about them in the past.

I actually managed to find something using SEDAR “Plus” (let’s save my analysis of this for another post) and fetched out their declaration of trust. Via their Annual Information Form, here is the following snippet:

the REIT shall not incur or assume any indebtedness if, after giving effect to the incurrence or assumption of such indebtedness, the total indebtedness of the REIT would be more than 65% of GBV (including convertible debentures);

(FYI – GBV = Gross Book Value)

Let’s do some math.

In June 30, 2023 their assets were 1.826 billion. Their total debt was $1.166 billion. That’s about 64%.

So they’re hitting up against a debt wall.

This gross book value will surely decline as all REITs mark their books as a function of the government treasury bond rate – as the risk-free rate rises (and has it ever!) your asset values will decline.

Very shortly, Slate is going to be debt-locked unless if they take efforts to reduce their GBV. This can only come in the form of an equity offering (not going to happen when your units are trading at $1.52 a pop and a total market cap of $120 million), an extremely dilutive preferred share offering (George Armoyan to the rescue), or selling real estate assets.

The problem with selling your real estate assets is that you’re only likely to be able to sell in short notice the assets that are actually worth something, compared to the rest of the sub-par garbage you have in your (pun intended) asset slate. Not only that, but selling such assets might trigger the need to value your other assets accordingly (i.e. the cap ratio you were assuming on your books isn’t what you’re getting when you sell the asset!) which would then cause the GBV to debt ratio to increase even further.

In other words, CCAA could be in the cards here. I’m glad I walked away from this one. Twice!

Rediscovering the logistics behind pizza delivery

Home pizza delivery was a huge innovation when it was invented many decades ago. Business-wise, however, it made absolutely no sense for the business to take the risk – it was incumbent upon “independent contractors” to execute and pizza chains were all too happy to incur the risk, while there was an implied expectation by customers that delivery implied some sort of service charge. The business model for the contractors is simple – they got to take a depreciation and operating expense on their vehicles (at least the fraction they claimed as part of their business use) and who knows how much of their cash gratuities they actually declared to the CRA!

Fast forward to today, and we have services such as Uber Eats, Skip the Dishes, Doordash, Fantuan, etc., that all brutally compete against each other in a typical low margin race to the bottom. Needless to say, the value chain in this entire operation is terrible from any investor’s lens. I do get some amusement seeing people in brand-new Teslas driving with Fantuan logos on their vehicles – presumably their own calculations think that they are driving fuel-free while they take advantage of their 1-year Tesla supercharger subscription but are delightfully ignorant of other depreciation aspects of vehicles.

So imagine my reaction when I saw today’s news release from Goodfood (TSX: FOOD) as they desperately try to continue to diversify away from their nearly-dying business segment of semi-prepared food delivery:

Goodfood and PIANO PIANO Partner to Deliver Premium Pizzas Nationwide

Toronto’s acclaimed Italian restaurant group is partnering with a leading Canadian online meal solutions company to deliver premium pizza in first coast to coast distribution deal

TORONTO and MONTREAL, July 31, 2023 (GLOBE NEWSWIRE) — Goodfood Market Corp. (“Goodfood” or “the Company”) (TSX: FOOD) a leading online meal solutions company and PIANO PIANO the Restaurant Group (PIANO PIANO), a renowned Italian restaurant with five restaurant locations across the GTA and producer of premium frozen pizza are making it even easier to bring the restaurant experience into your home.

Goodfood members in Eastern Canada now have access to delivery of a party pack bundle of 3 of the bestselling pizzas from Chef Victor Barry’s PIANO PIANO Italian eatery which includes customer favourites: Sweet Hornet, Mushroom & Onion, and Pepperoni. Later in the summer, this offering will be expanded to Goodfood customers in Western Canada and the teams are working closely to add more menu hits to customers at home.

I see the logic in FOOD management trying to figure out how they can utilize more of their existing supply chain distribution, but something makes me think that picking up a fraction of sales from third-party distributors will run into a critical mass problem – you’re not going to get the Dominos, McDonalds, KFC-type volume. Instead, you’re only going to sign up a whole bunch of dis-aggregated niche vendors (probably ones that are disgusted with the fees of the existing offerings) and this is going to create huge fixed costs to integrate your logistical operations with each and every one of them. The other issue is that delivery logistic companies are a brutally competitive space. What makes their offering more cost competitive than Uber Eats and the like, especially considering a good portion of their (Uber Eats, Doordash, etc.) “independent contract” labour pool is likely grey-market?

The lower end of the labour market is not a friendly space to be in – in order to make any living, the people working in this sector are working brutally hard, but this is one of the signs of the new economic times that is a pretty good barometer of watching our collective standard of living decline further and further – long gone are the 1950’s to 1970’s days of a single wage earner being able to provide for the family and pay down the house mortgage. Now you need two people plus side gigs in order to just put that roof on your head.

When you get it wrong but are still right

Investing is a weird art in that you can be wrong with your theories but still end up ahead. The converse is true (although when you lose despite being correct, I must say it is a lot more annoying).

Ag Growth (TSX: AFN) announced they settled with their customers in regards to a three-year old incident involving an installation of a grain tower:

We are pleased to confirm that a mutual settlement agreement has been entered into with Fibreco that settles all matters between AGI and Fibreco relating to the Bin Incident. AGI expects to record an additional pre-tax charge of approximately $15.6 million in the second quarter of 2023 in connection with the Fibreco settlement, including insurance recoveries that will be received. We believe the settlement between AGI and Fibreco will help to facilitate the finalization of other insurance-related matters.

In the past March 31, 2023 quarterly report, the following paragraph is mentioned:

Over the period of 2019–2020, AGI entered into agreements to supply 35 large hopper bins for installation by third parties on two grain storage projects. In 2020, a bin at one of the customer facilities collapsed during commissioning, and legal claims related to the incident have been initiated against AGI. As at March 31, 2023, the warranty provision for remediation costs is $40.7 million [December 31, 2022 – $41.5 million], with $0.8 million of the provision having been utilized during the period.

… there is a long history of expenses associated with this incident, from Q2-2021:

Based on remediation work completed thus far, we have recorded an additional $7.5M to the previously disclosed $70M accrual. The increase is primarily the result of additional engineering, steel, and labour costs required to ensure a satisfactory product solution as well as additional legal costs. To-date, the Company has spent approximately $25M of the accrual.

… from Q4-2021:

As at the end of December 31, 2021, the Company has spent approximately $43.4 million of the $86.1 million total accrual, which was increased by $8.6 million in the quarter to reflect an updated view of the costs to resolve the issue.

So this whole debacle will have costed AFN about $100 million in total. Needless to say, for a company the size of AFN (generating $102 million in cash flows through operations in 2022) that is a huge amount – over $5/share!

So why is the stock up? Beats me!

It is not like I did not do any due diligence on this case – I went to Vancouver Supreme Court to dredge up the civil case files to see if I could get some colour on the incident. There were some interesting documents in the stack of papers in the file folder. A professional engineer apparently was way out of his depth with the design of the grain towers and I figured the blame would get pinned on his liability insurance (and hence AFN would be able to claim their own insurance against his), and I figured that I might as well hold the shares (instead of dumping it) for the inevitable (favourable to AFN) payout. Obviously I was out of my depth on this one since it is clear that AFN completely lost the case with this settlement where they have to take an additional $15.6 million charge.

Yet, the stock is still incredibly close to its all-time highs and 2023 looks to be a record year for the company. Go figure. It’s a little disturbing that I don’t have a clue what I’m doing with this one. Just reading the financial statements, they continue to have a lot of financial leverage but management has been making noise lately about actually paying down debt which would make everybody involved more comfortable.

It continues to be a huge investment despite how out of depth I am.

Late Night Finance with Sacha – Episode 25

Date: Tuesday, July 18, 2023
Time: 7:00pm, Pacific Time
Duration: Projected 60 minutes.
Where: Zoom (Registration)

Frequently Asked Questions:

Q: What are you doing?
A: Quarterly review, economic thoughts, and time permitting, Q+A. It’s been an uneventful quarter, do not expect fireworks. Please feel free to ask them on the zoom registration if any questions.

Q: How do I register?
A: Zoom link is here. I’ll need your city/province or state and country, and if you have any questions in advance just add it to the “Questions and Comments” part of the form. You’ll instantly receive the login to the Zoom channel.

Q: Are you trying to spam me, try to sell me garbage, etc. if I register?
A: If you register for this, I will not harvest your email or send you any solicitations. Also I am not using this to pump and dump any securities to you, although I will certainly offer opinions on what I see.

Q: Why do I have to register? I just want to be anonymous.
A: I’m curious who you are as well.

Q: If I register and don’t show up, will you be mad at me?
A: No.

Q: Will you (Sacha) be on video (i.e. this isn’t just an audio-only stream)?
A: Yes. You’ll get to see me, but the majority will be on “screen share” mode with MS-Word / Browser / PDFs as I explain what’s going on in my mind as I present.

Q: Will I need to be on video?
A: I’d prefer it, dress code is pajamas and upwards.

Q: Can I be a silent participant?
A: Yes.

Q: Is there an archive of the video I can watch later if I can’t make it?
A: No.

Q: Will there be a summary of the video?
A: A short summary will get added to the comments of this posting after the video.

Q: Will there be some other video presentation in the future?
A: Most likely, yes.