Asset stripping in inter-corporate relationships

Whenever researching companies that have control over other corporations, it is quite important to pay attention to signs of agreements between both entities that are to the benefit of one or another. Today’s example is fairly textbook.

This news release from Dream Asset Management (TSX: DRM) hit my mail feed this morning:

TORONTO, April 23, 2019 (GLOBE NEWSWIRE) — Dream Unlimited Corp. (TSX: DRM) (TSX:DRM.PR.A) (“Dream”) announced today that Dream Asset Management Corporation (“DAM”) has agreed with Dream Hard Asset Alternatives Trust (the “Trust”) and Dream Alternatives Master LP (“Master LP”) that until December 31, 2020 the management fees payable to DAM pursuant to the management agreement of the Trust will be satisfied in units of the Trust (“Units”) valued at the recently reported net asset value per Unit of $8.74 for purposes of determining the number of Units to be issued, subject to the receipt of required regulatory approvals and unitholder approval at the upcoming meeting of unitholders of the Trust to be held on June 17, 2019. DAM has agreed to accept Units in satisfaction of the management fees in order to increase its ownership stake in the Trust and to preserve the business’s cash to support the cash distributions by the Trust while the Trust seeks to increase the market value of the Units by offering to purchase Units. As of the close of business on April 22, 2019, DAM and its joint actors own 13,386,072 Units representing approximately 18.6% of the issued and outstanding Units.

Notably, Dream Unlimited and Dream Hard Asset Alternatives (TSX: DRA.UN) are run by the same management team. When skimming through the financials of DRA, the bulk of their portfolio consists of various real estate ventures ($118 million), equity-accounted for investments in the real estate sector ($133 million), commercial/development lending ($144 million), income properties ($224 million, notably shared with two other related Dream entities), a solar and wind power asset ($130 million), and finally some cash ($47 million). On the liability side, they have $195 million in loans outstanding, most of it ($123 million) mortgage loans.

Book value is $592 million. Trust units outstanding are 72.6 million, so the NAV at the end of December 2018 is $8.15/share. (I know the above release cited a $8.74 NAV – this is reconciled on page 2 of the MD&A but it is not terribly relevant to this post).

The trust reported $8.3 million in operating income, plus another $3.3 million in interest income, for a total of $11.6 million before taxes (note as a non-REIT trust they would pay a tax on income distributions, but since those distributions are mostly return of capital at this point the taxation is entirely within the consolidated portions of their asset portfolio – a great future CPA taxation topic I would be more than happy to write about!). At their stated distribution rate of 40 cents per unit, they would require $29 million a year to pay this.

The summary is that they are holding onto a lot of private assets and while they can likely be liquidated in the medium term (especially the real estate holdings), in the short term they are distributing more cash than they are able to generate without selling such assets. They are not in a desperate situation and have the luxury of time to optimize matters.

Likely due to the controlled ownership situation, coupled with the illiquidity of their underlying portfolio, they are trading at a discount. Before today’s announcement they were trading at $7.20/unit, so they were about 11% under the GAAP book value, and around 18% using management’s revised NAV estimate.

At the same day, DRA announced:

As part of its strategic plan announced on February 20, 2019 to enhance unitholder value, management and the Board confirm that the units of the Trust are an attractive investment opportunity and are committed to deploy up to $100 million towards its unit buyback program (representing just under 20% of current market capitalization). Providing further clarity on the execution and timing of the unit buyback program, the Trust now intends to make three offers to unitholders in accordance with applicable securities laws, the first of which is expected to be made on or about July 15, 2019 for approximately 4 million units at an offer price of $8.00 per unit and two subsequent offers will be made in 2020 for $30 to $35 million of units at prices of at least $8.25 and $8.50, respectively, for a total buyback of $100 million of units prior to the end of 2020. These buybacks compare to the closing price of the units on the TSX of $7.17, as of April 18, 2019. The exact number of units that the Trust offers to purchase and the timing of such purchases will be determined by the Trust at the time of launching such offers subject to the receipt of the expected proceeds from capital recycling and the trustees’ obligation to act in the best interests of unitholders. The Trust has been advised that Dream Asset Management Corporation, the Trust’s asset manager and an 18.6% unitholder does not intend to tender any units to such offers.

In this release is a non-binding promise to initiate a partial tender at prices above current market value.

DRM’s entitlement in 2018 was $13.6 million. By opting to receive units at $8.74 compared to today’s market value (currently $7.70/unit), assuming prices, the management fee, and NAV remains constant, DRM has opted to graciously donate about $1.6 million to the unitholders of DRA. While this is not a gigantic amount of capital in relation to the sizes of the entity, it does give a hint as to where management is prioritizing the reception of its capital allocation.

This is another example of how a related party transaction is a red-flag show stopper with regards to an equity investment prospect. Dream Unlimited is relatively cheap in theory, but to invest in it you have to completely in for the ride with regards to the whims of management (the control character is Michael Cooper). This has not prevented me in the past, however, from investing in what used to be the best and nearly risk-free 7% eligible dividend in the form of (TSX: DRM.PR.A), but sadly the market has gotten smart about it and management should be calling it when they wish to realize the quickest 9.2% pre-tax use of capital.

Hat tip to Tyler on Twitter for this one. I had intended to write about this when it hit my inbox, but I saw that he wrote about it first.

Investment companies, agency, and Difference Capital / MOGO Merger

Most corporations that specialize in maintaining equity portfolios typically trade less than their component parts, simply due to the control issue. Shareholders generally have little control or say on when the company can reach their purported net asset values. Management usually has an incentive to not sell off their companies so they can collect salaries and/or benefits and/or power that comes with control.

As a result, it is a very relevant consideration before investing in such vehicles that the incentives of management are in line with your incentives (presumably as a minority shareholder). Some managements do care about their overall shareholder base (Berkshire presently I would judge to be part of this category, although they are much more of an operating company than most think), while most generally regard minority holders as an annoyance to be mitigated. It is rare where minority shareholder groups will organize to a point where a credible proxy fight can be contested, but such contests are expensive and usually the bias is toward incumbent management. A good example of a failed proxy fight was the contest for Aberdeen International (TSX: AAB) in early 2015 (a very brief legal summary is here).

Aberdeen was a notable case where it was trading far below its net asset value and the share structure did not have super-voting shares. The dissident group failed to accumulate enough support and shares to overthrow the board. Aberdeen at that time was trading at 15 cents a share and the book value was roughly 40 cents. Today they are down to a market value of 5 cents per share.

There are plenty of other cases to examine with these types of companies. Dundee Corporation (TSX: DC.A) is a conglomerate with consolidated and non-consolidated investments and has been trading below book value for a considerable period of time. In their last annual report, I highlight the salient page which shows that their operating entities are not doing too well:

Dundee is a dual class structure, with the founding family controlling the entity via super-voting shares. In order to resolve a situation with a redeemable preferred share issuance (which I have written about in the past) they also notably diluted their shareholders – issuing about 42 million shares to go from 61 million to approximately 103 million shares outstanding effectively – at a conversion price of $2/share. After this conversion, the parent company will hold no material debts and management will have a lot more time to be able to figure out how to transform the operating businesses into profitable entities. Presumably until this happens, Dundee will be trading under book value.

The last entity I will point out is Difference Capital (TSX: DCF). They were notable with having “Dragon’s Den” titan Michael Wekerle being their original CEO and lead investor and they invested in a whole smattering of private placements and various business ventures.

This didn’t quite work out for them for the majority of their history. In 2018, they able to focus on monetization of their portfolio in order to mostly pay off a convertible debenture. The remaining part was financed with a 12% secured loan which was partly paid for by insider money. In their year-end of 2018, they held a net asset value of $7.20/share on their financial statements and this was contrasted with a $3 share price (indeed, shortly after the new year, they executed on an asset disposal that spiked their share price up to $4) – hardly a risk for insiders to take when they were first in line on security and taking a nearly guaranteed 12% return – the shareholders are the ones effectively paying for this.

The final monetization of their company was announced on April 15th – however, it was to another company called MOGO Finance Technology (TSX: MOGO) which is chaired by Wekerle and 22.4% of MOGO is already owned by DCF.

DCF is nearly majority controlled by Wekerle (47% via a holding company that he wholly owns). Thus, a DCF shareholder has to ask whether their interests are aligned with his.

The agency issue is whether DCF minority shareholders benefited from the MOGO transaction. The obvious answer, when looking at the financial situation, is no. It reminds me of what Elon Musk did when he merged SolarCity and Telsa together – SolarCity was about to financially fail, but Musk wanted to fold it into Tesla to avoid the negative attention that such a failure would cause, with Telsa shareholders picking up the bill to deal with the entrails of that transaction.

Instead, this transaction was likely to give MOGO some financial breathing space as they were effectively buying the residential value of DCF’s private equity portfolio and more importantly, cash.

MOGO is bleeding significantly serious amounts of money:

The cash shortfall is significant. Operationally, MOGO is not in terrible shape – they reported an operating income loss of $4 million in 2018. The real deficit in MOGO is the cost of their capital. They have $75 million outstanding on a credit facility, $42 million in non-public debentures (ranging from 10% to 18% interest), and $15 million in 10% convertible debentures (TSX: MOGO.DB). When reading the fine print on the credit facility, the following is the key paragraph (note the underlined):

On September 25, 2017, the Company finalized a new senior secured credit facility of up to $40 million (“Credit Facility – Other” and, together with the Credit Facility – Liquid), which was used to repay and replace Mogo’s previous $30 million entered into on February 24, 2014 (“Credit Facility – ST”). This transaction resulted in the extinguishment of the Credit Facility – ST. On December 18, 2018, the Company increased the borrowing limit on the Credit Facility – Other from $40 million to $50 million. The facility bears interest at a variable rate of LIBOR plus 12.50% (with a LIBOR floor of 2.00%) up to the first $40 million of borrowing, a decrease from the variable rate of LIBOR plus 13.00% (with a LIBOR floor of 2.00%) under the Credit Facility – ST. The incremental portion of facility borrowings above $40 million bears interest at a variable rate of LIBOR plus 11.00% (with a LIBOR floor of 2.00%). Consistent with the previous facility, there is a 0.33% fee on the available but undrawn portion of the $50 million facility. The Credit Facility – Other matures on July 2, 2020, compared to the maturity date of July 2, 2018 under the previous facility. The amount drawn on the new facility as at December 31, 2018 was $44.3 million (December 31, 2017 – $28.8 million) with unamortized deferred financing costs of $0.2 million (December 31, 2017 – $0.2 million) netted against the amount owing.

You’re not going to get rich borrowing money at LIBOR plus 12.5%! Indeed, as a percentage of revenues, interest expenses are 28% – they will never show a profit at that level of interest bite.

Hence the presumed justification for the merger with DCF – Michael Wekerle has invested significant resources into MOGO. MOGO is borrowing money at exorbitant rates and DCF will add some assets to MOGO’s balance sheet, which can eventually be liquidated for desperately needed cash.

Does this in any way benefit non-controlling shareholders of DCF? Not at all. This explains why DCF traded down after the transaction and MOGO traded up.

Currently, MOGO has a market capitalization of $80 million (this is after it received a good 15% rise after the DCF announcement). Will they be able to find cheaper financing? Most of their debt matures in 2020.

But either way – this is yet another example of making sure to check the motivations of controlling shareholders before you jump on board – you might find they will make decisions that will have little to do with adding value to the stock and instead use the entity for other strategic purposes.

Bellatrix Exploration recapitalization

The carnage in the small-to-mid cap Canadian oil and gas sector continues.

Today’s interesting news is the recapitalization proposal of Bellatrix Exploration (TSX: BXE).

In this process, I’ll walk through the financial statements and this will give you a snapshot of how I go through these things. Indeed, this is not exhaustive, but a small part of the thought process.

Readers with exceptionally good long-term memory will know that I had an investment in their debt a very long time ago. Indeed, you can read about a minor exit trading error I made on the investment.

I haven’t touched Bellatrix since (9 years ago!), but still keep track of things. You never know when future opportunity may strike.

Bellatrix, just like most smaller Canadian oil and gas companies, has been really struggling.

From the cash flow statement:

The key 2018 figures include CAD$52 million in EBITDA (not including impact of hedging), but the “I” is $41 million (cash cost is $35) and the “DA” is about $70 million of capital expenditures. People that are untrained at reading financial statements of oil and gas companies will be swayed by the syren’s voice of operating cash flows without due regard in consideration to how much capital expenditure it actually takes to sustain those barrels of oil (equivalent) per day.

In other words, the entity bled about $54 million cash in 2018. Without a change in oil price, the company is going nowhere financially.

On the balance sheet, we note that the company has no cash on hand (cash is provided by a credit facility) and is capitalized by debt financing. This next picture is a gong-show illustration, so forgive me:

This is a company that is in very bad shape on its balance sheet. People that look strictly at financial metrics will see a $672 million book value (shareholder’s equity) and they will say “Hey! That’s over $8/share in value, and with the stock trading at 50 cents that’s a bargain!” but in economic reality, most of that equity value consists of already spent money that takes place in the form of Property, Plant and Equipment – exploration expenses that are capitalized and not expensed. Whether these assets have any recovery value or not depends on economic assumptions of the price of fossil fuels.

The company also has germane issues with its solvency – so we have to dig into the credit facility and debt financing:

We discover the company can borrow up to CAD$95 million and that this facility is first in line, and is up for redetermination at the end of May. This is not a good sign.

The next in line to maturity are the senior notes (which are third ranking, US$145.8 million par outstanding) and this matures in May 15, 2020 (not that far away). The first and second in line creditors will not allow a third-line creditor to jump them in maturity, so this has the makings of a classic credit crunch, which has to be solved. One scenario is that the credit facility provider will choose to extend the timeline another six months to facilitate a recapitalization, but in no way would they ever allow the senior notes to be repaid without huge assurances they would be paid first. Note the second-line noteholders do not have the ability to directly compel BXE to not pay the Senior Notes, but there are covenant issues regarding the loaning of money that is adverse to the interests of the second-line noteholders.

There are other issues regarding covenants which I will ignore for the purposes of this analysis (this adds a layer of complexity which in itself is interesting but I don’t wish to get into this post).

Now we get to the meat of the recapitalization proposal:

* an exchange of all of the Company’s outstanding 8.5% senior unsecured notes due 2020 (the “Senior Unsecured Notes”) for, in the aggregate and taking into account early consent consideration, a combination of US$50 million of new second lien notes due September 2023 (the “New Second Lien Notes”), US$50 million of new third lien notes due December 2023 (the “New Third Lien Notes”) and approximately 51% of the common shares of Bellatrix outstanding immediately following the implementation of the Recapitalization Transaction; and

* an exchange of all of the Company’s outstanding 6.75% convertible debentures due 2021 (the “Convertible Debentures”) for, in the aggregate and taking into account early consent consideration, approximately 32.5% of the common shares of Bellatrix outstanding immediately following the implementation of the Recapitalization Transaction.

…

* it is a condition to completion of the Recapitalization Transaction that the Company’s existing senior bank credit facility (the “Credit Facility”) (which currently matures on November 30, 2019) be extended for a one-year term on terms substantially similar to those currently in place;

The summary is that the company is asking their US$145.8 million senior noteholders to take a US$45.8 million haircut in exchange for 51% of the equity in Bellatrix, and also to become pari-passu (equal standing) to the second-ranking noteholders for US$50 million and effectively extend their own notes for another 3.5 years. The convertible debentures (CAD$50 million par, who are last in line on the pecking order) will receive 32.5% of the equity in Bellatrix.

Existing shareholders will keep 16.5% of the company, in exchange for offloading CAD$50 million plus US$45.8 million in debt, but the company will also receive a term extension on the primary part of its debt until 2023 (when everything becomes due).

The company obtained consent of 90% of the senior note holders (so passage becomes inevitable), but the question then becomes – what if the convertible debenture holders do not agree to this? They received consent from somebody owning 50% of the debentures, but with regards to the other 50%, they cannot be “force consented” unless if a sufficient number of them vote in a class to recapitalize (I am not sure what the threshold amount is).

The debenture holders, if they do not agree, can be told by the company that they will go into CCAA to force the matter (where they will receive nothing in return, instead of the 32.5% equity they are being offered today).

Hence it is interesting that the convertibles are trading up about 10 cents on the dollar today to 60 cents – valuing the remaining equity (plus the encumberance of the second-lien debt and credit facility) at CAD$92 million.

By no means does this recapitalization put Bellatrix on a good financial standing – certainly offloading CAD$111 million in debt will be good for the company, but the underlying operations still need an assist on the price of oil. If this recapitalization does go through, there are still considerable headwinds to be faced.

Mistakes in investing – a couple examples

I’m going to reciprocate Tyler’s mention of a previous post of mine, and give him due credit for the following: My Biggest Mistakes.

There are mistakes of commission and mistakes of omission.

The idea is when you make mistakes of commission (and they will happen), is to quickly recognize them, take losses, and move on. Ideally the losses can be kept relatively small (let’s define this as 0-20% of the original investment) instead of them developing into 40-50% losses.

Simple math illustrates why avoiding large losses are desirable: If you take a 10% loss, you need an 11% gainer to break even. If you take a 20% loss, you need a 25% gainer to break even. If you lose half, you’ll need something to double. Suffice to say, finding something that will double in the future is a lot more difficult than finding something that’ll appreciate 25%.

When looking over my track record, the types of mistakes that I have made over the past half decade or so have typically been ones of omission. Not buying IRobot (Nasdaq: IRBT) at the end of 2015 is something I am still kicking myself for. I usually require significant margins of error before pulling the trigger, and also I typically have cash allocations that are well above what a normal portfolio should have. Including my components of preferred shares (which are invested in companies that are predictably stable and are in zero danger of suspending such preferred share dividends, and have improving credit profiles), one could fault my investment style for not performing well enough – if I have a quarter allocation of cash and I can continue to generate double-digit percent returns, why shouldn’t I just spread the cash in the existing portfolio components?

Psychologically, I need to sleep well at night, and cash allows me to do this.

My biggest mistake of commission, by far, was in IMRIS, a medical imaging company. The original investment was back in 2012.

Medical imaging has a lot of barriers to entry. There is a chicken-and-egg problem: hospitals don’t want to deal with small providers because there are issues with support and maintenance. In addition, procedures and the “soft” side (training, hospital administration in line, etc.) has to all be in order.

The thesis, condensed: IMRIS had an innovative product (a movable MRI machine) that, from my research and knowledge about medical imaging, was actually useful. They had successful installations in various hospitals around the world, and they were starting to build the critical mass of credibility needed to make it through the next inflection point where they would hit the big time (or get bought out by a major such as McKesson, Siemens, GE, etc.). They had a significant shareholder (which presumably would not let the company go under).

They made a strategic decision to relocate their corporate headquarters from Winnipeg to Minneapolis, for the reason that it would be easier to procure US capital investment. This should have been a huge warning sign (an international corporate relocation is going to cause huge disruption to the operations of the business and I should have bailed out the nanosecond I read this) but I thought the other factors were too compelling.

Each quarter, management was promising they were on the cusp of this breakthrough, and each quarter, the financial results coming in were sub-par. Eventually, they ran out of money and had to agree to a debt financing arrangement in September 2013. The terms were quite onerous and I knew the game was up, and sold out for a very significant loss.

A couple years later they filed for bankruptcy protection. I would have lost everything had I held on.

The business itself turned out reasonably well for its new (private) owners. According to a 2017 press release, they obtained record revenue growth and bookings. Obviously one can’t see the financial statements of this now private entity, but I think the original investment thesis was valid – just that they ran out of money, which happens in these types of ventures which have long lead times with unpredictable sales funnels.

I was looking for an Intuitive Surgical (Nasdaq: ISRG) situation where they managed to reach that inflection point of critical mass, and once that happens, you achieve very large investment returns. ISRG is another example of an error of omission.

Going back even further, one of my most embarrassing losses was losing a moderate amount of capital on an investment in the debentures of Sterling Shoes. They declared bankruptcy in 2011. I just barely managed to unload my debentures (for around 20 cents on the dollar) before they filed for CCAA protection. This was simply an instance of me not understanding anything about the dynamics of the retail market they were engaged in – this was an error of pure incompetence.

Admitting mistakes, continuously looking for information that will dispel your investment thesis, and rectifying the situation as quickly as possible are traits of good investors. Investors that aren’t able to elaborate on mistakes they have made in the past are likely doing themselves a disservice.