What do you do if you’re a steelmaker?

Steel factories at this moment must be facing a huge dilemma.

When your industrial process involves millions of tons of materials, you can’t exactly click a button on Amazon to get your feedstock – you need to order your inputs months in advance, if not years through a long-term supply contract.

So when prices are sky-high for metallurgical coal as they are, do you continue waiting and increase the risk that you will get no supply, or do you bite the bullet and secure a contract today?

At high prices, you are very unlikely to procure a long-term contract (who wants to lock in record-high prices on the buy side?). But you run the risk of not being able to properly price out your raw product to your own customers. It is a terrible situation.

We have a Q1-2022 pricing article that has the following:

US coal mining firm Arch Resources is offering a January-loading Panamax cargo of Leer high-volatile A coal at $410/t fob US east coast, with expectations of securing at least $400/t fob. The Leer high-volatile A coal continues to command a premium in the market, being particularly well-established in the Chinese market. “We are having trading firms chasing us pretty hard for high-volatile A coal into China,” said another US mining firm that said a European buyer was seeking 30,000t of high-volatile A coal last week. “We would be pushing for above $400/t fob ourselves.”

(fob US east coast, for those unfamiliar with shipping, means that once the coal is loaded on the east coast ship, the buyer pays and it is the buyer’s risk in the event of any catastrophe).

US$400/ton is a lot of profit, especially on a company with a US$50-60/ton cost structure. How long will this party last? Will any producers be able to supply long-term contracts at these prices, or will demand for steel plummet?

The booming fossil fuel industry

Over the next few weeks, oil and gas companies will be reporting their third quarters and give projections based off of the existing strip pricing.

For gas producers, winter gas prices appear to be headed to around CAD$5/GJ (AECO pricing), while if you can get the stuff onto a tanker and ship it to Japan or Korea, it’s going for about US$35/mmBtu (one million BTUs is about 1.06 GJ).

The spot oil price has also gone up about US$10 since the last slew of quarterly reports.

The first shot that was fired was on October 14 when Whitecap Energy (TSX: WCP) announced its 2022 capital plans and projections. In addition to ramping up production mildly (from 111k boe/d to 122), at a US$70 WTI price (note that spot crude is US$83 as I write this), they anticipate generating $911 million in free cash flow, and this is after capital expenditures and accounting for some idiotic hedges that will result in some considerable losses.

Let’s focus on the $911 million in free cash flow. At the end of Q2-2021, WCP had $1.3 billion in outstanding debt, and a market cap of $4.8 billion. This works out to a 15% return.

Others in the Canadian energy complex have similar metrics.

De-leveraging has been the focus of all of the companies – I suspect they are getting concerned that the banks and financial institutions are going to be pressured to “defund” or put pressures on their credit lines (a “climate surcharge”, etc.). Debt financing can be focused on bond issuances rather than relying on lines of credit.

In the case of Whitecap, as their dividend payout rate is very low, if they keep on their existing track they will be able to eliminate most, if not all, of their line of credit by the end of 2022. Out of the $1.3 billion in debt they have at June 30, 2021, $740 million is bank debt and $595 million are in senior secure notes – $200 million maturing in January 2022, May 2024 and December 2026.

The even rosier news for the industry is the lack of material capital investment in the sector. This gives huge incumbency advantages for the existing players. Traditionally at this phase of the boom-and-bust cycle, you would hear companies pouring billions of dollars in extra capital spending, but companies today are being very cautious. While market valuations would suggest that this pricing level is temporary, I would bet against that. Although prices will never move in straight lines in the short term, the overall trend is quite positive.

Headlines are too panicky

There is a cliche and that is that markets do not crash when everybody is fearful.

Glossing over a few headlines today, we have:

  • ‘Global equities are likely to be under pressure in coming months’: Citi
  • Households that made money in the pandemic should prepare for some financial pain
  • Eyeing higher inflation and volatility, investors turn more selective: fund managers

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    Almost nobody out there is saying “buy stocks”.

    I’m not saying GME is going to a thousand dollars, but I wouldn’t bet my life on it NOT happening.

    Dorel will have a lot of cash leftover

    Dorel announced the unloading of its sport division today for US$810 million.

    This company was trading for less than CAD$2/share during the pits of Covid-19 and made its way back up to $16 (management attempted to go private at this price) before sliding down again to $10.42 on the last Friday close.

    I have held the company in the past, although it was one of the ones that I jettisoned during Covid in favour of others (which turned out to be a mistake, but c’est la vie).

    My chief complaint about this company was that the entrenchment of management and their very large compensation was a bit off-putting. The business itself is quite diversified, one level up from retail on the value chain – still very low margin and they probably will be facing significant cost and logistical pressures with all of the supply chain anarchy going on.

    After they conclude their sports division sale, however, they’re going to have a lot more cash to deal with. If you zero out their debt and cash, and the added proceeds of US$810 million from this sale, you are left with about US$446 million net cash at the end of the day.

    On 32.5 million shares outstanding, that’s about CAD$17/share in cash alone.

    The company will have a capital gains tax bill to pay off as a result of this transaction, but it still will be in a strongly cash positive position, which means it is most likely they will give out one huge special dividend when this is over with.

    It will be interesting to see how this stock will trade on Tuesday morning – undoubtedly it will be higher, but how much?

    Looking at the 52-week losers on the TSX

    In these strange times where Facebook employees can’t get into their own building because of some technical issue, and half the world has to resort to the indignity of SMS because WhatsApp is down, I bring you some observations on which companies have fared the worst over the past 52 weeks.

    In general, the list contains a lot of gold and silver miners that have done the worst, coupled with some biotechnology companies. Marijuana has also not done very well.

    I try to avoid gold mining companies like the plague and hence I do not really want to dive into any of them, but notable names which stood out include New Gold (TSX: NGD), Sandstorm (TSX: SSL) and an old friend in Gran Colombia Gold (TSX: GCM).

    Outside of this sector, the known and recognizable names on the loser lists is quite sparse. Mediagrif, now mdf (TSX: MDF) is a company that I’ve looked at in the past but have not invested in them. They were a fairly benign SaaS company (probably their most known software offering was MerX) that recently executed on a large-scale acquisition last August with a subsequent equity offering. This acquisition sucked up the cash on their balance sheet and added some leverage to purchase a company that is barely profitable. Large acquisitions very rarely work out and the stock price is certainly reflecting this. People tend to view the entire SaaS sector monotonically when in reality, there are huge valuation rifts between various software offerings – you can’t simply slap on a Constellation Software-sized price to sales ratio on every company that does SaaS!

    Another name which caught my attention was MAV Beauty Brands (TSX: MAV). This is a branding reseller company (i.e. take generic products, put a brand label on them, and get them on the shelves of stores). Some of you may guess that I am not the biggest consumer of hair products. You would likely see this company represented in the shelves of Shopper’s Drug Mart. The company is mildly profitable, but they’re not exactly in the best competitive position – just go to the hair-care section at the store and you’ll see why. At a market cap of CAD$90 million they might seem cheap, but they also have a US$140 million term loan to deal with which really guts the valuation proposition.

    Moving further down the list of 1-year losers, we have Ballard (TSX: BLDP) which I won’t dissect further – they continue to execute on their very successful business model of raising equity financing every decade when there is hype regarding hydrogen power: “On February 23, 2021, the Corporation completed a bought deal offering with a syndicate of financial institutions for 14,870,000 shares of the Corporation at $37.00 per share, resulting in gross offering proceeds of $550,190,000 and net offering proceeds of $527,291,000” – this will last them another 6 or 7 years!.

    The first name which got me legitimately interested was Richards Packaging Income Fund (TSX: RPI.UN), which looked like they were a somewhat-COVID victim, but upon subsequent research I also tossed this one in the discards pile. If they were trading at half of what they were currently, I might have been more interested.

    We all remember the toilet paper craze from Covid-19 and KP Tissue (TSX: KPT) was one of the companies that benefited from Covid-19. No longer – you can take a look at them now. They are an extremely leveraged entity.

    Finally, something else that caught my attention was Saputo (TSX: SAP), the dairy conglomerate, and they are reaching 52-week lows and are likely candidates for year-end tax-loss selling. Covid-19 has disrupted the business and its profitability. While the stock is still at a healthy price, if it depreciates by another 1/3rd or so, it may get into value territory. Dairy is effectively controlled and protected in Canada by Saputo, Agropur (a co-op) and Parmalat (European-owned), which gives it some monopoly-type characteristics.

    Overall, the pickings are very, very slim. The companies that have dropped over the past 52 weeks have really done so for proper reasons. I’m not finding a lot of value out there, and the low P/E names are mostly in the fossil fuel space and they have appreciated extremely.