Canadian preferred shares – commentary

Early 2016 was a good time to invest in Canadian preferred shares, and there was also a lot of carnage in the equity market at the time. Five-year government bond yields bottomed at 0.48% in February 2016, and you can see the damage it did to the preferred share market – ZPR is an ETF that tracks 5-year rate resets:

What is interesting is a well-timed entry on the bottom (not completely clairvoyant, but say $7.50/unit) and an exit anytime between October 2017 to 2018 would have netted a total return that exceeded the TSX with less risk. Of course, you can’t determine those preferred shares will do better than the TSX when you’re sitting at your computer console in February 2016!

Today’s investing environment has plenty of parallels – the 5-year interest rate has dropped to 135bps from 240bps back in October. If 5-year yields continue to drop further, there is a high degree of likelihood that preferred shares will also be sold down to levels seen in 2016.

The question is getting the timing correct.

A lot of retail investors get burnt by buying into a relatively high yield product thinking it is safe. While the yield itself may be safe (it has been awhile since I can recall a dividend suspension in the Canadian preferred share marketplace beyond Aimia and some really garbage split-share corps), the capital is most certainly at risk. It looks like a very easy leveraged trade on paper when margin rates are 2.5% and you see a financial instrument at 5%, but how much pain can you take when the yield goes to 6%? 7%? You’ve just lost nearly 17% and 29% of your capital, respectively.

Using a real example, investors in Brookfield Preferred Shares series 30 (TSX: BAM.PR.Z) back in September was trading at par, had a near-guarantee 4.7% yield, and a rate reset of 2.96% over the 5-year government bond rate. Some enterprising chap sees margin rates at 2.5% and decides to invest $50,000 cash to buy $100,000 of BAM.PR.Z. Now they’re sitting on $23,000 in equity plus $3,500 in accumulated dividends and they would have surely received a margin call (or would be very close to one). How much of the population out there is leveraged to preferred shares in this manner and are feeling nervous? How many will hit the sell button to take the tax hit and move away from this “guaranteed leveraged return”?

Ideally when they all want to cash out, that’s the time to get in. Doesn’t quite feel time yet.

Hudson’s Bay – Internal take-over

This is a few days late, but the headline coming from (TSX: HBC) is: “Shareholders Collectively Owning 57% of Hudson’s Bay Company’s Outstanding Common Shares Submit Take-Private Proposal for C$9.45 per Share in Cash”.

Almost anybody investing in this company from 2018 back will have lost money.

Today, HBC announced a very tepid quarterly report (this surely is not coincidental to the timing of the take-private offer – gives it some urgency to accept it). Sales down, gross profits down. Not good.

The takeover offer gives a $1.74 billion valuation to the equity, which I think existing minority shareholders will take in a heartbeat. I can’t see anybody else step in and give a better offer.

I think it is pretty inevitable that HBC will cease ordinary retail operations very soon – they either have to go very specialty or just get out of the business – a struggle not unknown to other retailers which have also been hammered to death as purchasing trends continue to shift.

Atlantic Power / Williams Lake

There is a staggering degree of government regulation with any projects of significance. This creates competitive barriers to entry for would-be entrants.

The most public of these projects are oil pipelines, but even operating power plants are subject to a ton of public scrutiny and the wrath of the public.

Atlantic Power operates a biomass power plant in the northwestern outskirts of Williams Lake, BC, generating up to 66 megawatts of power.

They had applied in 2016 to amend their permit to accept the chipping and burning of used railroad ties. The BC Ministry of Environment approved this, but it was appealed on behalf of certain residents of Williams Lake, BC. The BC Environmental Appeals board ruled on April 11, 2019 that Atlantic Power could burn an average of 35% rail ties as its biomass each year, up to 50% on a daily basis. The community group that effectively lost the appeal took it to City Council, but council denied their request (which, in any respect, would be non-binding).

In 2018, Williams Lake generated $8 million in EBITDA. The main power purchase agreement expired on April 1, 2018 and has been extended on less favourable terms on a short-term basis.

Finally, for those that are willing to get into the nitty-gritty of the technical assessment of Atlantic Power’s biomass power plant in Williams Lake, you can read the 2016 technical assessment concerning their request to burn rail ties.

Gran Colombia Gold’s confusing capital allocation strategy

One yellow flag for investors is if company management starts to deviate away from previously professed strategies without giving reasonably decent justification for such changes.

Since 2016’s recapitalization, GCM has been focused on improving its mining operations (so they could pay back the debt incurred from the recap). The debentures issued in the 2016 recapitalization were redeemed and refinanced in May 2018, which provided less restrictive covenants for the debt that was issued (TSX: GCM.NT.U).

At the end of June 2018, GCM had about US$32 million and US$98 million in notes outstanding. For the first half of 2018, they generated US$14 million in “excess cash flow”. They continue to generate excess cash flow today.

The point of the above narrative is to illustrate that GCM’s financial situation is a lot more favourable than it was three years ago. They have a lot more flexibility to invest internally in their own operation (Segovia, Marmato), but they have taken an interest in Sandspring Resources (TSX: SSP).

We continue down the timeline:

  • July 26, 2018– GCM buys CAD$4 million of SSP, also receives shares for Chicharron project in Segovia (they sold their 30% interest to SSP for 15M SSP shares, about 5km east of GCM’s current operation in Segovia – SSP owns 100% of it now).
  • October 3, 2018 – GCM buys another CAD$1 million of SSP
  • February 11, 2019 – GCM buys another CAD$0.7 million of SSP

Everything to this point is consistent – now that they have capital, GCM chose to invest in a project in Guyana.  I don’t really like these corporate inter-relationships since there is so much room for error, but at least the strategy is consistent.  After this date, things get screwy:

  • March 1, 2019 – GCM files for an equity offering, wants to raise gross CAD$25 million. Warrants for C$5.75, stock price to be determined by market. Stock crashes. Cited reason for the capital offering: Accelerated drilling in Segovia.   It raises the hidden question – why are they dumping money in SSP (CAD$5.7 million to date plus disposition of 30% Chicharron stake) if it was better spent on drilling in Segovia or Marmato?  GCM earned US$44 million in free cash flow in fiscal 2018, is this not enough?  GCM ended 2018 with US$39 million cash+equivalent and the only debt on the books was the US$89 million in GCM.NT.U.
  • March 4, 2019 – GCM opts to change the offering and raises CAD$20M instead in debentures (convertible at CAD$4.75), CAD$18M from MM Capital Partners, CAD$2M from insiders.
  • May 30, 2019 – GCM will be buying 2/3rds of a $3 million non-brokered placement (another CAD$2 million of SSP) – this was “up-sized” two days later to a $4 million placement – not clear whether the 2/3rds applies to the $4 million or whether it will be a $2 million commitment.  Let’s assume $2 million.  As of the date of this writing this has not been confirmed. (Update, June 12, 2019: $2 million investment)
  • June 10, 2019 – NCIB announcement. Wasn’t this capital supposed to go to Segovia drilling?  In fairness to management, this does not commit them to repurchasing shares, but it does signal odd capital priorities (raising capital three months earlier, only to buy it back?).

MM Asset Management, the firm that bought the CAD$18 million in debentures, filed June 10, 2019 that their stake is now 6,510,699 shares of GCM, plus $18 million in debentures, for a consolidated ownership of 19.77% if they convert (doesn’t factor in the dilution with the outstanding warrants, however).

To date, GCM has sent CAD$7.7 million into SSP stock (with the $2 million invested on June 12, 2019).

I find these capital allocation decisions to be highly mysterious.  Now that the debt covenants have been relaxed (you can read the restrictions in Section 5.10 of the indenture – condensing the legalese, the material points are a 50% consolidated net income (note: as defined on page 9) restriction, subject to a $10 million or 2.5% tangible net asset floor), GCM has the ability to dabble externally and also with its own stock.

At least there is protection for Noteholders.