Re-visiting Canadian preferred shares

Back on June 24, 2019 I put a notification out that Canadian preferred shares were looking interesting, but really flubbed with the timing. At the time 5-year government bond yields were 20 basis points less than today.

Sadly my sense of market timing let me down and I was only able to procure a 1% position in a rock-solid issuer’s preferred shares. Too bad – was looking at deploying a significant amount of cash there but this one got away from me. Early June perhaps was the time to get in.

It’s pretty obvious a bunch of institutional money stampeded into the market and this gets bubbled into algorithmic purchases of these securities, which typically have quite large spreads.

In general, however, I do note that physical infrastructure preferred shares (e.g. energy, Brookfield, etc.) exhibited a much higher price increase than financials – the typical rise for a physical infrastructure preferred share trading at 2/3rds of par value has been around a dollar, while the financials have had about half of it. In most instances, securities trading with “minimum rate resets” have been ridiculously overpriced, but there was one that looked reasonably attractive for “boring capital”.

If 5 year yields drop again we could see prices on preferred shares drop again – I’d welcome it. In the meantime I’ll look elsewhere.

Reitmans / Substantial Issuer Bid / Taxation

Hat tip to Tyler for getting this on my radar. I’ve personally been following Reitmans (TSX: voting stock RET, non-voting stock RET.A) on-and-off for the past decade or so. Not that I’ve been a purchaser of women’s clothing but financially it is a typical story of the decline of a fairly benign women’s fashion retailer facing the steamroller of competitive marketing and the internet.

Fortunately for Reitmans, they are highly un-leveraged. As of May 4, 2019, they have $122 million cash and zero debt. As Tyler pointed out, IFRS 16 had a disproportionate impact on the reporting of their balance sheet – I will point out any accounting system does not change the actual economics of a company’s operations (other than covenants and restrictions that are governed by the stated accounting values!).

On June 3rd, RET announced their quarterly results, which were less than inspiring (sales down, margins down, cash drain increased from the previous year’s quarter) and their stock tanked. There was a panic sale before somebody with larger pockets decided they wanted to accumulate shares in the low 2’s.

On June 17, RET announced a substantial issuer bid (SIB) for CAD$3/share of up to 15 million shares of RET.A stock. There were 49,890,266 shares outstanding, so the 30% SIB is not a trivial amount – and also nearly 40% of the cash on RET’s balance sheet. The voting stock has 13,440,000 shares outstanding and this will be untouched – directors and insiders have 56.9% control of these shares, although if you want to be a muzzled voting partner, the stock does trade a few thousand shares a day on the TSX.

Shareholders have until July 26 to figure out whether to tender.

The SIB was filed on SEDAR, but I will spare you the trouble and attach it here.

I always find these documents interesting to read, specifically the background of the transaction. Merger documents also have to include the timeline of discussion and negotiations. For RET’s SIB, it is as follows:

During the spring of 2019, senior management of the Corporation was approached by a significant unrelated Shareholder indicating its desire to realign its portfolio and to sell all of its Shares. As a result, such members of senior management and the Board of Directors began engaging in preliminary discussions concerning possible strategic activities and opportunities that may be in the best interests of the Corporation and could provide enhanced liquidity for all of the Shareholders. Among the alternatives discussed was the possibility of pursuing a substantial issuer bid to repurchase a portion of the issued and outstanding Shares.

“a significant unrelated Shareholder” is not defined in this document, but my first guess is Fairfax.

I’m sure another alternative was trying to find a buyer for the company, but this would require the control group agreeing to it.

In May 2019, following discussions with senior management of the Corporation, certain independent members of the Board of Directors seriously considered the possibility of pursuing a substantial issuer bid and the alternatives thereto. Given the Corporation’s significant cash on hand and marketable securities portfolio, certain independent members of the Board of Directors and senior management of the Corporation considered that, in light of the trading price of the Shares, the low return from its investment in marketable securities and interest rates earned on the cash balance, a substantial issuer bid would be a good use of the Corporation’s funds and sought preliminary advice from Davies Ward Phillips & Vineberg LLP, legal counsel to the Corporation, in order to further consider and evaluate the possibility of making an offer to repurchase a portion of the Shares.

The key word is “certain” in “certain independent members of the Board of Directors”. Clearly this was not a unanimous decision.

The rest of the document is bureaucracy to adhere to MI 61-101 and is not terribly juicy.

Taxation (hat tip to Fred for this one)

This is for Canadian residents.

A Resident Shareholder who sells Shares to Reitmans pursuant to the Offer will be deemed to receive a taxable dividend on a separate class of shares comprising the Shares so sold equal to the excess, if any, of the amount paid by Reitmans for the Shares over their paid-up capital for income tax purposes. Reitmans estimates that the paid-up capital per Share on the date of take-up under the Offer will be approximately $0.66. As a result, Reitmans expects that a Resident Shareholder who sell Shares under the Offer will be deemed to receive a dividend. The exact quantum of the deemed dividend cannot be guaranteed.

Careful – if you tender your shares, you will receive a deemed dividend of $2.34/share! Fortunately your capital gain will be reduced (in most cases, one exception is if you just bought the shares before/after 30 days of the final disposition) by said amount, which will lessen the tax bill somewhat. Unfortunately, almost all shareholders of RET are sitting on loss situations – so in order to take full tax advantage of the situation you would need to be able to offset 3 years’ prior capital gains, or future capital gains. Otherwise, you are taking a very large tax hit to tender your shares.

Putting on my individual CPA tax advisory hat, in general, if your desire is to dispose your shares of RET, you should ask yourself whether taking a dividend with a relatively large capital loss (the tender route) or a relatively small capital loss with no dividend (sell in the open market) is better for your personal taxes. RET.A shares are trading at around $2.85 presently so going through the open market approach will involve surrendering a potential 15 cents per share, offset with the tender route uncertainty that at a minimum, only 30% of your shares will be tendered.

Virgin Galactic thoughts

Apparently Virgin Galactic is going public, via a SPAC currently traded as (NYSE: IPOA). The SPAC is a Cayman Islands shell capitalized with US$708 million cash waiting to be invested by its control owner, Chamath Palihapitiya. Before the Virgin Galactic announcement IPOA was pretty much trading at salvage value (it has a designated 2 year lifespan to invest in anything before it had to be liquidated):

When reading the news, my initial reaction was that IPOA would jump to the roof, as the market itself (space tourism) is relatively untapped from a publicly traded perspective. I wanted to flip the stock like pancakes on a griddle. IPOA was going to receive 49% of the Virgin Galactic entity.

The powerpoint deck associated with the announcement is located here. Skip to page 55 – financial overview for the meat of what an investor would be buying into.

Somebody investing in IPOA is taking a blind leap of faith. Why would Virgin sell a huge stake in the business if it was actually going to generate the numbers claimed? The presentation talks about being EBITDA profitable in 2021, but the underlying reality is that if you can’t even get a low cost domestic flight company (with two leased Airbus 320s) going without injecting a ton of capital and a lot of pain, what makes one think that running a one-of-a-kind rocket ship is going to be any different? The other question is – who in their might mind will pay US$250,000 for a ticket to a 55-mile above planet earth trip and do it again? There doesn’t appear to be a lot of ‘repeat’ value in these types of trips unless if they can make them similar to SpaceX’s vision of a 1 hour trip to anywhere on earth (which, if reliable and repeatable, I could see a true market for – it won’t happen because of noise pollution). But it also brings up the question of operational risk – one crash and the business is shot for at least half a decade.

Whenever I get the compulsion to buy something based off of a news headline in the Drudge Report, I solve this by performing imaginary day-trading. I inevitably lose money in my mind, and that relieves the psychological burden of not being involved. Of course, it is more agonizing when you look at entities like Beyond Burger and ask yourself what you’re doing reading balance sheets and income statements.

One of my negative screens is that if I read about some company on the mainstream news and it is not portrayed in an excessively negative light, I tend to exclude it as an investment candidate. The less attention given to a specific company means there is likely to be more value to be had by a closer examination. Markets are strange in this respect. But with Virgin Galactic, I’ll be a happy spectator and wish them the best of success – what they do is cool, similar to SpaceX.

Genworth MIC potentially on the selling block

Genworth Financial (NYSE: GNW) owns 57% of Genworth MI (TSX: MIC). GNW has also been subject to a merger agreement with a China-state owned entity, China Oceanwide, which proposed acquiring GNW for US$5.43/share. One of the conditions is the approval of the various regulatory authorities. The key stumbling block appears to be the Canadian regulator, and as a result, GNW is proposing to explore selling the MIC entity.

There are two questions. One is who would purchase MIC, and the second is the valuation. Surely the acquirer would have to be a Canadian entity – my guess is that the CPPIB or provincial pension arms would be ripe candidates (which would ensure that substantially all of the Canadian mortgage insurance market is held by crown corporations). There are not a lot of insurers that would have the capacity to take on MIC – obvious candidates include MFC, SLF, GWO, FFH or IFC.

The market is up about 4% for MIC presently. There’s a pretty good case to be made that the transaction, if it were to occur, would have a fair value higher than the presently selling stock price, but I don’t see any potential acquirers over-reaching beyond CAD$50/share or so (which I think is the price that GNW will want to get). It just depends on how badly GNW wants this merger to complete – a purchase of GNW presently would gain 46% in value if the merger was completed – and they have huge issues of their own with respect to their long-term care insurance liabilities.