Melcor REIT – another cutting distributions to zero

Melcor REIT (TSX: MR.UN) is a small REIT containing 38 properties that is controlled by parent Melcor (TSX: MRD). The book value of assets are $700 million, debt about $420 million and about $12 million in cash flow from operations each in the past couple years. At 13 million units outstanding and at $3/unit, I will leave it up to you to calculate the market capitalization and relative size of this trust to others.

On March 5, 2024 they announced their year-end results. While the actual results were tepid, the big news was the trust finally reduced its distribution to zero citing financial flexibility.

Putting a long story short, they are hitting a debt wall as outlined by one of their significant holders, FC Capital in a letter that came public on March 13.

I won’t delve too deeply into this other than that we have a couple themes in action with this and Slate Office and other marginal REITs:

1. Debt maturities are killing equity value
2. The valuation of illiquid private equity (or in this case illiquid property holdings which is almost as bad) on balance sheets is highly suspicious when it comes to the time that you actually need to liquidate said properties.

You’ve got Allied (AP.UN), Dream Office (D.UN), Artis (AX.UN), H&R, etc, etc., all trading at wildly deep discounts to book value. The financial engineering solution is to liquidate the assets at their stated value and watch the magic happen, right? If it only were that simple!

Just wait until the CPP and other pensions that are heavy on “private” or otherwise illiquidly-valued assets finally get their day in the valuation sun.

In the meantime, the REITs appear to be a reasonable canary in the coal mine, begging central banks for supplemental oxygen.

Microstrategy cornering the Bitcoin market

A moment of market history was when the Hunt Brothers attempted to corner the market on silver (Silver Thursday), which occurred from 1979 to 1980.

If the article is accurate, the Hunt Brothers at one point controlled a third of the world’s privately available silver supplies, primarily using futures contracts.

The collapse of the scheme occurred when the highly leveraged Hunt Brothers could not post sufficient equity to keep their margin loan going.

Fast forward 44 years and we have the situation with Microstrategy and Bitcoin, which appears to be an analogous situation.

On March 11, 2024 via Form 8-K, Microstrategy announced they had purchased 12,000 Bitcoin, during the period between February 26, 2024 and March 10, 2024, for $822 million, mostly with the proceeds of an $800 million convertible debt offering (0.625% coupon, maturing March 15, 2030, convertible into equity at $1498/share). After this filing, Microstrategy owned 205,000 Bitcoins purchased at a cost of $6.91 billion.

I will note this date range of the purchased Bitcoin appears to line up exactly with the rise from $53,000 per Bitcoin to around the $67,000 we see today:

This wasn’t enough.

On March 15, 2024, Microstrategy closed another convertible bond offering, $525 million (0.875% coupon, maturing March 15, 2031, convertible into equity at $2327/share). Unlike the previous offering, this offering claimed to be used for general corporate purposes and the purchase of additional Bitcoins.

With the stock price (after a 15% drop as of the writing of this article) at about $1,500 a share, they are obviously continuing to leverage themselves to the hilt in order to keep the price of Bitcoin high. The liquidity of Bitcoin itself is somewhat questionable – throwing $820 million into Bitcoin over 10 trading days is enough to spike it around 30-40% in value. Microstrategy is clearly trying to keep as much gasoline onto the Bitcoin fire as it can, as its market valuation is tied to the hip with it. The primary owner and chairman, Michael Saylor, is dumping stock like crazy while the going is good.

My only question is when will this house of cards collapse?

The answer is strange – it depends on whether the stock collapses. It may not happen soon. The looming debt maturity was going to be in 2025 with a $650 million convertible note, but it is likely that it will be converted at approximately $398/share. The next looming debt maturity are the 2027 notes, which has a conversion price of $1432/share, which is much closer to the current stock price.

As long as the company can keep the stock price up and be able to avoid raising cash (presumably by selling Bitcoin!) in order to pay for the maturity, this can go indefinitely.

The cycle would be: issue equity or convertible debt financing -> purchase bitcoins -> raise the price of bitcoins -> higher MSTR stock valuation -> issue equity or convertible debt financing

The question will eventually be settled by somebody with deeper pockets than Microstrategy that decides to short enough Bitcoin and also Microstrategy stock to get an even larger payoff in the subsequent collapse. They would need to force Microstrategy to sell its Bitcoin.

Fairfax gets a short selling hit piece

Muddy Waters put out an interesting hit piece on Fairfax, accusing the corporation of using accounting tricks to overstate its true book value by about USD$4.5 billion. FFH’s stated equity in September 2023 was USD$21.6 billion. This accused mark-down isn’t gigantic, but considering that Fairfax is trading at a healthy valuation over book (about 1.5x 1.2x) a valuation with a constant P/B multiple metric would result in an approximate 20% haircut all other things being equal. The stock is down about 10% today as I write this.

Skimming through the presentation, the bulk of the accusation is centered around the accounting of purchases of various subsidiaries and not taking or being able to cleverly avoid write-downs.

Fairfax is a massively complex entity and the stated financial position of various entities, whether in Fairfax or in other entities that try to do private market equity (or even real estate valuation for commercial REITs!) is ultimately up to a management judgement using some semi-standardized variables. The reality of these valuations are achieved when the entity involved tries to liquidate the venture in question.

The other accusation revolved around the application of IFRS 17 and the subsequent accounting adjustment in contrast to other insurance firms. Among other items, IFRS 17 applies a discounted value to the expected liability component of an insurance contract payout. Muddy Waters accuses Fairfax of being an outlier in relation to some other insurance firms. I have no good way of evaluating this other than that if a company anticipates its insurance payouts longer in the future, the stated liability reduction will be greater.

Finally, from the IPO to present, I did note that Farmer’s Edge was a disaster, including that of Fairfax, and its privatization offer is probably some attempt to internalize Fairfax’s upcoming loan loss on that venture. The amount, relative to the whole Fairfax consolidated entity, is small beans but blowing a high 8-digit figure of money is not chump change for most mortals like you and I!

I’ve looked at Fairfax here and there over the past couple decades and while there was a reasonable valuation case to be made when it was in the 400-500s, I found the stock to trade rich lately, even without the news of this particular short selling report. Ultimately the firm’s ability to dredge out cash flows from its insurance operations (which the metrics are quite excellent if they are to be believed!) is what is going to matter, not necessarily the stated book value of the various subsidiaries and minority investments on its balance sheet – if your assets are generating (this is a made-up number) $2 billion dollars cash a year, it doesn’t matter whether you keep them on your balance sheet at $20 billion or $30 billion – you’re getting $2 billion of cash – just that your return on assets metric will get skewed as a result.

Of course, if you compensate your management on the increase in book value per share instead of free cash flow, you will likely get a result where your management will pull out every derivative contract trick on the planet to artificially goose up the book value number. I suspect this may be the case if the report has any validity.

Either way, I have no position in Fairfax, and not too much interest either aside from watching this as a financial spectator.

Investing in AI – Corvel

I unintentionally made an investment in an AI company. You can read my original thesis on May 27, 2020. Like most companies around that time, it was trading heavily down during the Covid crisis. Indeed, my intentions were everything other than investing in AI at the time.

Fast forward nearly four years, the stock has rocketed upwards to valuations that are difficult to rationalize.

The company is operated by a reclusive management and they have very terse press releases. They quit doing their no-question conference calls (which gave slightly more colour to their business operations) after their January 2023 quarter. No analysts follow the company, there are no EPS estimates, and almost nobody knows that this company has a huge competitive advantage in its niche.

Amusingly, I have noted they have been using the two-letter “AI” phrase in the last few press releases.

On May 27, 2021, they first used the words “artificial intelligence” in their press release:

CorVel Corp. applies technology including artificial intelligence, machine learning and natural language processing to enhance the managing of episodes of care and the related health care costs. We partner with employers, third-party administrators, insurance companies and government agencies in managing workers’ compensation and health, auto and liability services. Our diverse suite of solutions combines our integrated technologies with a human touch. CorVel’s customized services, delivered locally, are backed by a national team to support clients as well as their customers and patients.

January 31, 2023:

The Company has also continued work in the area of digital transformation. Most recent efforts have focused on enhancing CorVel’s document repository system with AI-centric technologies. The advancements being implemented automate the extraction and codification of critical data, which can then be leveraged dynamically within systems. The development roadmap for the quarter and beyond includes increased automation and augmentation, which will further optimize bottom-line results and outcomes.

May 25, 2023:

In other areas, CorVel is moving forward quickly and intentionally, using generative AI in a closed-source data environment. The technology will be incorporated into CogencyIQ® service offerings and has extensive benefits. Most importantly, generative AI will elevate the work of claims professionals and allow more time to be spent interacting directly with injured workers. The reallocated time will ultimately improve the experience of injured workers and enhance partner outcomes.

August 1, 2023:

CorVel’s 1st generative AI initiative will be released in the September quarter. The release will reduce mundane, repetitive tasks and provide decision support at critical inflection points. This automation will add to the existing machine-learning tools with increasing capabilities within the system. The Company also views generative AI as an effective tool to mitigate labor challenges and provide guidelines for future generations of professionals. In the quarter, investments in the foundational systems and workflow processes continued to strengthen the results achieved with CorVel’s products and services.

October 31, 2023:

In the payables market, developments were made in both the revenue cycle management arm, Symbeo, and the treasury services department. At Symbeo, hyperautomation, a combination of AI, machine learning, and robotic process automation technologies, presents an expanded opportunity in the market. By using Symbeo’s payable solutions, partners receive the benefits of touchless digital invoices, AI enabled optical character recognition, a machine learning Document Classification model, configurable AP rules, and standard ERP integrations via Robotic Process Automation which provides faster invoice cycle times, lower total cost of ownership, and an enhanced user experience.

Finally, today, on January 30, 2024:

The implementation of generative AI initiatives has been proven to boost the efficiency and effectiveness of both the P&C and Commercial Claims teams. These updates have gradually reduced time spent on routine tasks, thus creating more time for essential activities that require critical thinking, directly impacting the user experience and results achieved.

…

With today’s earnings release (the 3rd fiscal quarter for the company), we have a past 12-months EPS of $4.32/share. The company historically has been able to slowly increase its per-share earnings both through a combination of higher net income and also through the deployment of a significant share buyback program which has been running for a couple decades – the capital allocation strategy appears to be holding about $100 million cash in the bank and dumping the rest of the free cash flow into buying back shares. While the company has been able to reduce its shares outstanding by 139,000 shares from December 2022 to 2023, much of the $55 million spent was to offset prior option issuances. Needless to say, with the stock price as high as it is, those equity options are all entirely in-the-money.

Focusing on the $4.32/share, this gives a backward-looking P/E of 55, which makes Corvel the richest (highest valuation) stock I currently own. The valuation has me concerned, but I can easily see a scenario where for some reason the hype decides to bid it up even further. It is very difficult to predict these things. Who is to say that the capitalized value of their software technology is not worth well greater than the $4 billion market cap? Maybe some insurance giant wanting to internalize their own software operations (and de-licensing competitors) would be a strategic bidder for $8 billion in stock? My guess is about as good as anybody else’s.

While this is still a top-5 in my portfolio, I did pare a little at the 200 level to justify my sanity a little bit. But instead of chasing Nvidia, I will take solace in this – at least the company itself is set to generate cash for a very, very long time.

Yellow Pages – What now?

By virtue of two mandatory share redemptions (post 1, post 2) and some other dispositions, my position in this company is a lot less than it used to be (which at one point was over 10% of my portfolio!). However, what is remaining is not an insubstantial sum as measured in dollars and cents and I also have some sentimental value with this company as I regard it as one of my best calls ever which I made public on November 2019. Indeed, it is my longest-dated portfolio holding.

Other than capital return decisions (which has reduced the company’s shares outstanding from 26.6 to 14.2 million), the other significant event appears to have happened on March 21, 2023:

On March 21, 2023, the Company was the target of a cybersecurity incident. The Company immediately activated its internal network of IT professionals and retained the services of cybersecurity experts to assist in securing its systems and to support its internal investigation. The Company also suspended its operations and IT systems to contain the situation.

As of May 10, 2023, the Company had restored all its operations and IT systems and has taken steps to further secure all systems to help prevent a similar occurrence in the future. The Company is working with its insurance providers to make claims under its policies.

In their Q2-2023 release, they stated when discussing their decline in revenues:

… (b) a cybersecurity incident which resulted in the Company’s operations and IT systems being suspended for approximately three weeks of the second quarter of 2023.

While this did not have a material impact on Q2 (I was jokingly thinking that the company is so old-school that it generates cash even when they don’t have any computers operating), it certainly had an impact on Q3’s metrics, which significantly underperformed the decline regression model I had.

Now that this incident is over with, presumably the company can get back to its regular decline.

The only difference is that instead of working with a base of 26.6 million shares outstanding, there is about 47% less shares out there to deal with.

Management explicitly wanted to get the last buyback out of the way in calendar 2023 because of the 2% buyback tax that was going to be imposed in 2024. It would suggest that future buybacks are unlikely – perhaps this is why the stock is edging down lower due to the lack of anticipation of future demand.

This is an odd case where a company has removed nearly half its shares outstanding, but the share price has actually decreased despite the underlying financial metrics being relatively stable (the graceful decline downward). The company continues to trade at less than 4x cash generation – if there is any hints that profitability will stabilize, this multiple will rise. This has always been the thesis and 2024 is probably a good a year as any to see if it occurs. If there was ever a case study to deal with a company that should just go private to alleviate itself from public company hassles and expenses, this one is it. In the meantime, the dividend yield is around 7.5%, so at least we’re being paid a few bucks to wait for the inevitable.