Kicking the can forward

Now that the European debt situation is seemingly resolved, the markets are now on rally mode. Credit is loosening again and this gets reflected in the price of debt and equity.

How long will be it before the other countries in Europe line up at the trough?

The fundamental problem is debt accumulation and it is not solved by a one-time papering over – somebody has to pay for it. It is just a matter of when.

Of course this is sour grapes because of my high cash position, and I do suspect that plenty of others are on the sidelines. This is especially for pension fund managers that have to make their mandated 7.5% return on assets while sitting on a mount of 10-year treasury bonds yielding 2.2%. They are forced to buy equities since there is no other assets that can possibly generate a higher return.

Commodities are also making a return, assisted with the US dollar depreciating again over the past month.

This is almost turning out to be a mirror image of the 2008 financial crisis – in October of 2008, the world’s problems were solved with things like TARP and QE, but it took another six months for the markets to fully digest it and reach a panic low. It is something I am open to believing may happen again.

Yellow Media preferred differentials

As I pointed out earlier, there was a significant yield differential between Yellow Media preferred shares C and D (TSX: YLO.PR.C and YLO.PR.D). The market has closed this gap now to about 0.7% if you use the most generous bid-ask spread quotations (e.g. the ask on the C’s vs. the bid on the D’s).

The common shares have gone on a massive surge over the past couple weeks, and this has translated into strong gains for those that have held their noses and accumulated positions during the meltdown.

The closest analogy I can think of what is happening is what happened to Telus (TSX: T) back in 2002 when the whole market dumped them down to $3.50/share for no real reason other than that they had a lot of debt and old-school telecom was on its way out.

Common shareholders face the most risk and will receive the most reward in a favourable scenario, but preferred shareholders will also come out very well and continue to receive income.

Of course this can all blow up if the next quarterly report is adverse. However, you would think after inking their last credit facility that they would have had some sort of visibility on their results to prevent an early default.

Risk on, Risk off

It looks like the risk-off trade is “on” again!

This risk-off, risk-on type market environment reminds me of this very classic scene that people of my era would remember, except dealing with wax:

Risk on… risk off. Master this and win the tournament, or rather have the pleasure of stuffing your wallet at the expense of other people that have decided to get bullish.

Yellow Media Update

Yellow Media (TSX: YLO) common shares have climbed up from their ultimate low of 12.5 cents on October 3, 2011 to 32 cents presently. There has been no news from them other than a press release stating they have been named one of Canada’s top 100 employers for the 6th year running.

Instead, this appears to be a matter of the stock being taken down to the basement level by a stampede of funds trying to desperately get out. Now that anybody that wanted to get out did, supply in the market seems to have been alleviated and the price is now rising.

The business fundamentals remain the same after a month – the company is highly leveraged, but is cash flow positive and has a feasible plan to paying off its debt through internal operations assuming the revenue decay is not too extreme.

Preferred shares continue to trade strangely, with the Series 3 (TSX: YLO.PR.C) trading with a yield about 4.5% higher than Series 5 (TSX: YLO.PR.D). I guess nobody reads the prospectus on these things anymore.

The equity-linked preferred shares, Series 1 (TSX: YLO.PR.A) and 2 (TSX: YLO.PR.B) continue to be coupled to the price of the Yellow Media equity. Series 1 will probably be converted into shares of Yellow Media (12.5 shares per preferred share if the common stock price is less than $2.05/share) on April 2012, while Series 2 stands a good chance of being converted in July 2012, depending on financial results.

While the Series 3 preferred shares trade at around 19 cents of par, convertible debentures are at around 33 cents.

The next big data point for the company is November 3, 2011, where they have already pre-announced a $2.9 billion goodwill write-down. While this will of course result in a grossly negative earnings per share for the year, it is a non-cash charge and the remaining questions for investors will be focusing on the cash flow statement at this release date. As I have repeatedly stated, if the company can produce results that are less than disastrous, they will stand a very good chance of surviving and being able to pay generous cash flows to their shareholders that are senior to the common.

In the favourable scenario, I would expect the market would see that Yellow Media will have the capacity of being in the position of paying off its obligations through internal cash flows and be in a position to raise financing sometime in the second half of 2012. If this occurs, the common shares should trade higher, but the preferred shares should also slowly rise to the 8-10% yield level, which translates into a $17-21/share price for the Series 3. The debentures in this case would also trade 1-2% richer than the preferreds, around 90 to 98 cents on the dollar.

The risk is that they won’t be able to make these financial targets and will be forced to restructure. The preferred shareholders will get wiped out along with the common shareholders. The unsecured debenture holders will likely get very little in such a reorganization.

The risk-reward was high and very high, respectively, and this is why I continue remaining long the preferred shares and debentures of Yellow Media. This is a relatively binary outcome with little middle ground which makes it a fairly unique opportunity.

Sterling Shoes not so shiny

Sterling Shoes (TSX: SSI) went into creditor protection today. The shares were halted at 1:27pm and the CCAA protection announcement came at 1:48pm. The TSX will delist the shares and debentures.

Investors would have had some advance warning given the announcement the company made on September 27, 2011 that they would not be able to make an interest payment on their convertible debentures. Their credit facility with the Bank of Montreal would have prevented them from making the payment.

At this point anybody that held equity in the company should have firmly jettisoned it and the company shares tanked from 37 cents the day before to about 12 cents after.

There still may be value in the debentures, although whatever slice of the company they are given in the post-restructuring is difficult to determine. The company had about $13M in secured debt and $25M in subordinated debentures. When compared to sales metrics (2010: $127M revenues, $54M gross profit) and potential profitability (i.e. there is ample room to cut SG&A by getting rid of under-performing stores), the company should be worth more than what the secured line of credit is worth – certainly, debenture holders going into the bankruptcy had not expected much, with the last trade going off at 13.5 cents on the dollar at closing.

The following is a chart of the debentures:

It is impossible for retail investors to get a fair shake at a company during a restructuring, but I do notice that Belkin Enterprises Ltd., lead by BC businessman Stuart Belkin, took a $2.573M face value stake in the Sterling Shoes debentures and announced this on September 2, 2011 on SEDAR. Was this a mis-timed investment or are they planning on participating on the subsequent recapitalization and capture value in a post re-organization stake?

I would expect such holders to get equity and warrants in the subsequent recapitalization.