Tim Hortons financial engineering

I noted with some amusement that some shareholders of Tim Hortons have been clamoring for the company to financially leverage itself (via the Globe and Mail). I am not an investor in Tim Hortons and will likely never be, but I took a brief look at the financial metrics driving the company.

One can assume the company in Canada is relatively mature. There seemingly is a per capita rate of Tim Hortons of one per ten people. This has been the case in almost any region in the country I have been in.

So the push southward is a logical strategic focus for the company, except for the fact that they can’t gain any traction in the USA. I find this to be a curious phenomena since this is one of the few cultural differentiators between Canada and the USA that I can think of – intuitively there shouldn’t be any reason Tim Horton’s can’t be as successful in the USA, but there is seemingly something wrong with their product mix.

As such, when looking at the financial state of the situation, the company is trading at approximately 20 times earnings and they have succumbed to the vocal shareholders calling for a share buyback. Right now, Tim Horton’s debt level is $530 million, which is a relatively safe level given their cash flow generation (for the first half of the year, operational cash flow is at $258 million and free cash flow at $171 million). Also note that the company does give out a 26 cent quarterly dividend, which took out another $79 million in cash for the first half of the year. The proposal to lever the company another $900 million to do a buyback will not accomplish much other than destroying shareholder value and making the company as a whole more financially brittle.

I do not think $1.4 billion in debt is an unsafe amount of money for the company (although it is at the upper end of the threshold I would accept if I was on the board of directors), but it does seem unnecessary to exercise this buyback at existing valuations.

Although it can be assured that Tim Hortons will exist in some form in the indefinite future, will it always be as profitable as it is currently? I would steer clear of the shares.

Kinross and other gold producers

I note today that Kinross (TSX: K) announced quarterly results but also eliminated their semi-annual dividend, citing uncertainty in the gold market (not to mention the company’s rather large debt burden).

Whenever you see corporations eliminate dividends, there is typically an adverse market reaction because management is signalling the fortunes of the company are not sufficient to sustain the dividend. There are frequent opportunities to profit from this if you believe the conditions that caused the dividend termination are short-term in nature. Another factor that accelerates the price decline is that dividend funds (or other mutual funds) that have in their portfolio management guidelines the requirement to only be invested in companies with dividends will be getting their robotic traders to sell shares to the market, which will also put downward price pressure on the stock.

Strictly in terms of financial theory, two identical companies, one pay a dividend and one not paying a dividend, should be trading at identical values (after adjusting for tax implications of shareholders and the associated reduction of balance sheet equity for the dividends given). However, the market has a very deep perception difference between income-yielding instruments and non-income yielding instruments – there is quite a high premium these days on income-bearing investments even when it makes no sense.

I note that after today’s quarterly report from Kinross that the stock is down about 3%, which is less than one would expect given the announcement. This might suggest that a bottom is forming around here, but I am far from being an expert analyst on gold mining companies, and I’m not about to become one in the next month. A lot of these companies have deep issues with cost containment – even though the underlying commodity price has skyrocketed from prices 10 years ago, the costs to extract the resource seemingly climb up at the same rate!

Investors should also be warned that commodities can trade under marginal costs of extraction much longer than one would intuitively expect!

Finally, recall that these resources all tend to fall into cyclical traps. The general public never catches wind until most of the hype has been priced into the respective shares. Recall in the past decade:

2006: Uranium
2008: Potash
2010: Lithium
2011: Rare Earths, Gold/Silver
2013: Bitcoins

Next is…?

Genworth MI – Q2-2013 report

Genworth MI (TSX: MIC) reported second quarter results yesterday. They continue being a cash generation machine, with the latest quarter reporting a 0.12% delinquency rate on mortgages and a 43% combined ratio. With this and some investment gains, the company was able to report $88 million in operating income, or 89 cents per share.

Severity on claims was also down to 30%, from 34% a couple quarters ago.

The only negative a discriminating investor could see is the amount of insurance written this quarter was down about 40% (translating into net premiums written down by 22%), but this is strictly due to the federal government’s intervention on mortgage rules. It will also have a corresponding positive impact on claim frequency as the insurance pool will be of higher quality. It should be important to note that insurance companies make profits on underwriting risks that are priced below actual risk, not on sales volume.

On the balance sheet side, the company remains overcapitalized and has commenced its share repurchase since early May; they bought back 2.01 million shares at an average price of $24.88/share. This was a very astute purchase. It is likely they will keep repurchasing shares from the market until the buyback is exhausted, which will likely be at the end of the third quarter at the rate they are going. After that, they will probably look at the share price before deciding whether to increase the buyback or just give out a special dividend. Tangible book value at the end of Q2-2013 is $29.48/share.

Otherwise, there is not too much to report in this quarter report that hasn’t already been covered in previous reports of Genworth MI. While it is not the screaming value buy it was back last year when it was trading at $18/share, at $28/share, it is still undervalued and the share price still represents a degree of skepticism on the Canadian real estate market and the fortunes of the parent subsidiary that owns 57.4% of Genworth MI (Genworth Financial, NYSE: GNW). As long as one does not forecast some precipitous collapse in the real estate market (which will occur if unemployment rises suddenly) or interest rates start to rise rapidly (which would cause a country-wide devaluation of real estate assets), I still am amazed that this company has traded under $30/share for so long. It will get there.

Investors are also paid to wait, with a 32 cent dividend, which represents a 4.57% yield at a $28 share price.

As people are aware, there are two major players in the Canadian mortgage insurance market: the 100% federally-owned CMHC, and Genworth MI. Both entities are making insane amounts of profits for their shareholders (in the former case, for the public, in the latter for the shareholders) and it is rather reassuring to know that there is alignment between the government’s interests and the company’s – mainly keeping the premiums for mortgage insurance considerably higher than what appears to be needed. This is obtaining duopoly-style pricing without all the media attention. Finally, investors in Genworth MI also have to take into consideration the motivations of the parent subsidiary, which currently seems to be in the role of a passive investor at the moment that is clipping dividend coupons and cashing out shares as needed (this is in proportion to the buyback). Whether Genworth MI gives out its cash as dividends or as a share buyback does not make too much difference to me, although back at $25/share I was quite happy to see the shares repurchased. At $28, lesser so, but the breakeven point would be $30 for me, where I’d believe it would generate more value for dividends to be the conduit for excess cash.

Suffice to say, I am still long and am not interested in selling at current prices. They are still trading at less than tangible book value and generated $1.85/share in cash for the first half of the year. Why would anybody want to sell unless if they are panic-stricken?

Junk debt is being accumulated

It is very evident that money is once again flowing into junk debt. I am finding every piece of junk debt securities being bidded up over the past week. Amazing what happens when the Federal Reserve talks about not wanting to ease up on quantitative easing – liquidity and party-time again for everybody! Back to the strategy of borrowing at 1%, and buy up those 8% junk debt securities and skim the spread… until the music stops.

Of course, I do not endorse or condemn this strategy – it will work, until it stops working. Such are the markets we are currently in.

Genworth MI update

Genworth MI (TSX: MIC) has been treading water since last March, but lately seems to have caught some upside momentum:

mic

Possible substantiations why the price is rising:

– Macroeconomic aspects of the Bank of Canada determining to keep short term interest rates low (which will enable more principal payments on mortgage and thus reduce default risk);
– No big blowups in the Canadian housing market;
– The stock repurchase of 71,540 shares a day since the last course issuer bid has been announced. In May and June they took about 2 million shares out of circulation – just over 2% of their shares outstanding, which will boost earnings per share by about 7 cents a year. This will also save the corporation about $2.5 million in cash flow a year from not having to pay out the associated dividends. They have sufficient cash reserves to keep this up for quite some time.
– Notably such buybacks (especially at around the $25 price they executed the buyback with in May and June) are accretive from a tangible book value perspective, i.e. every dollar spent in repurchasing equity actually increases the per-share tangible book value.

It looks like they were able to mop up the willing sellers out there at the $24-25 price range and the market is now bidding the shares at a price that is closer to fair value, but my own calculations suggest that there is more upside.

Management should continue repurchasing shares until roughly $30/share as these repurchases are clearly adding value. After that, they should taper the buyback and accumulate cash and consider a special dividend.

The corporation is generating considerable sums of cash and will not be in a position needing to raise capital. Its next debt maturity is December 2015, where they have a $150 million issue outstanding at a coupon of 4.59%. Considering they currently have $289 million in free cash balances, this will not be a problem to either just pay it off or to re-borrow the amount for a modest amount of financial leverage. This decision will likely take place sometime in the first half of 2015. If interest rates rise, they’ll just repay the debt. If interest rates continue at the historically low rates we are currently experiencing, then they’ll be able to get a good rate.

Disclosure: I do own shares, it is just over a year since I last took my position.