Mogo Debentures – observations

Scanning the TSX fixed-income trading list, one name stuck out at me: MOGO. They amalgamated with Difference Capital to shore up their balance sheet.

They have $12.7 million in debentures outstanding (TSX: MOGO.DB) which are trading at 93 cents on the dollar. Considering the short term maturity date (June 6, 2020) it makes for an effective 26% yield to maturity when adding on the 10% coupon they give out. What gives?

Mogo’s balance sheet has a lot of high-interest debt (especially in relation to its cash-negative operations), but they are slightly further back in maturity dates than the debenture’s June 6, 2020 maturity. In particular, they have (secured debt) $46.6 million outstanding due July 2, 2020 (with an interest rate of LIBOR+12.5%!) and $31.9 million due August 31, 2020 (LIBOR+8.00%).

These ridiculously high premiums over LIBOR should give an investor an idea as to what risk the banks are (thinking they are) taking in this firm, so at the very minimum, an investor should demand a higher rate of return on unsecured debt.

My guess is that management will be in a position to extend these credit facilities (barely), but one condition (among many) will be that the debentures are converted into equity.

Many convertible debentures have a clause that allows a company to convert them into equity based off of 95% of the volume-weighted average price for the past 20 days of trading on the TSX (usually 30 to 60 days of notice is required, so an investor can have a fairly good grasp as to what the conversion price will be), but I notice that MOGO’s is at the VWAP and not 95% of the VWAP.

It is likely an investor in the convertible debentures is going to receive shares. Today, Mogo’s market cap is 106 million, so a conversion of about 12 million par value is not going to take the stock down too much upon management giving notification of conversion.

Enterprising investors would think about shorting MOGO equity and purchasing the debentures, but sadly the borrow cost of over 20% makes this a prohibitively expensive trade.

I’m not interested in the debentures, but if you’re bullish on Mogo’s equity valuation (I’m not either) it is worth a gander.

Reversing course on a trade – Tailored Brands

A good part of investing is trying to constantly trying to figure out whether the information that got you into a trade is still applicable or whether it is flat-out incorrect. Unfortunately, the information that you glean from investing without insider information is diffuse and sometimes the decisions made are marginal ones – hence, it is never wise to bet too much of your portfolio on any investment thesis. More certainty of information over your perception of the information that others are pricing into the security allows for a more concentrated bet.

In the instance of Tailored Brands (NYSE: TLRD), it was a combination of diffuse information, hence a relatively modest position. There was a panic in September, coupled with management’s capital allocation decision to cut the dividend to zero, coupled with the actual numbers looking relatively cheap from a valuation perspective (they are a legitimate retail operation, albeit selling product that is facing an overall downtrend for various reasons). September quarterly guidance was very tepid which took the stock down:

* Men’s Wearhouse to be down 3% to 5%
* Jos. A. Bank to be down 2% to 4%
* K&G to be down 2% to 4%
* Moores to be down 4% to 6%.

I got in and out and flipped the stock like a pancake for mild profits. If you’re a large player, it takes a lot of time to scale in and out of stock positions and “pancake flipping” isn’t really an option – you’ll move the price of the stock too much on both ways.

What changed my thesis? One was that Gildan (TSX: GIL) is a precursor fashion company, and they pre-announced in October that things aren’t going too well. Obviously selling things such as t-shirts and underwear is not the equivalent of selling suits and fancy clothing (which involves more marketing and physical presence than raw material), but it was the continuation of the downtrend which is not a good sign. Does this guidance carry forward to other apparel retailers? Does TLRD’s already down-beat guidance already incorporate this, or will things be better than that or worse?

This is ultimately what makes it very difficult to judge as a market participant – what the market is currently betting on. Every piece of information is condensed down into one, and that is price – the assumptions driving the price among the market participants can only be inferred, and sometimes the causes for price changes are for completely hidden reasons (e.g. some hedge fund has to liquidate its entire holdings in a short time period at any price, and does so indiscriminately – these sorts of situations are great to get on the other side of the trades with).

The other reason why I closed out the trade was that I figured is that the psychological exhaustion associated with the suspension of the dividend, coupled with any anticipated benefits of a share buyback had played itself out. What I mean by this is that when a relatively well-known company suspends its dividend, there are many funds out there that invest in the company’s stock strictly on the basis that it has a dividend (any dividend or income-oriented ETF and so forth). These funds are forced to sell the stock within a predefined timeframe because they no longer fit the portfolio policy. Hence, when you see dividend suspensions, investors do not like it because it signals a negative psychology (Can’t pay a dividend anymore? Must mean you can’t make money to pay it, so I should sell!), but also for completely mechanical reasons (funds and ETFs selling due to policy).

Example: Vanguard at August 9, 2019 reported owning 6.8 million shares. Vanguard at October 10, 2019 reported owning 3.4 million shares. Vanguard, of course being the low-cost ETF provider of all sorts of funds running hundreds of billions of dollars of investor capital – pretty clear their income/dividend funds were getting rid of TLRD stock!

It could be the case that suspending the dividend to focus on stock buybacks is rationally the correct decision. Indeed, managements with value-creating characteristics would choose to engage in that, knowing that a dividend suspension would crater the stock price – it would just mean you can buy back more equity at depressed prices. The smartest managements time their annual option grants to coincide with this period, to get the lowest strike price!

Finally, TLRD’s cost of capital has increased considerably over the past month. This has been really noticeable over the past couple weeks where yields have risen on their July 2022 unsecured debt to about 10%, which is the point where the bond markets are getting quite nervous.

I’m guessing unsecured bondholders are not thrilled that some of the capital that is destined to pay them back is going into the hands of the stockholders. This is assuming management is repurchasing shares in lieu of the suspended dividend, but we will not get confirmation of that until the next quarterly report.

If there is a meltdown in TLRD, it will be very fast and spontaneous – similar to what happened to Toys R’ Us – bondholders will not have the opportunity to get out without taking a significant haircut. One big difference, however, is that TLRD still makes some money, so they have that going for them. That amount of money, as top line sales decrease, will be more and more difficult to realize without very diligent cost controls. It is one thing to manage a franchise that is on its way up, and another thing entirely to manage it on the decline – a whole different skillset is required to manage declines gracefully.

TLRD announces their next quarter on December 11, so we will see what happens. Such skittish trading is not the best way of making long-term gains but the cliche of cutting your losers quickly and let your winners run is also overriden by another cliche – when your original investment thesis is broken, get out. There’s always a market somewhere else.

Continental Gold merger – valuation – Gran Colombia equity

I’m not typically a gold mining investor. Gran Colombia Gold (TSX: GCM) was an exception but just by the method of how I got into the stock (via a debt to equity conversion). I’ve long since gotten out of it since it’s pretty clear management has other capital allocation priorities than optimizing returns for shareholders. I do still own their notes, which I expect to pay out high yield and low risk interest payments until they mature.

Today’s acquisition proposal of Continental Gold (TSX: CNL) by a Chinese company (Zijin) is interesting, mainly because of the very high valuation assigned – $1.4 billion of equity value (fully diluted).

Continental Gold is currently not producing, but is in the process of being able to produce gold sometime in 2020 with their Buriticá project in Antioquia, Colombia.

Building gold mines is not cheap. They’ve spent about $200 million on capital expenditures in the first 9 months of 2019. They had about $80 million left on the balance sheet at the end of September, so simple math would suggest that they needed to raise more money to finish their project.

They’ve got $300 million in loans outstanding, another $88 million in convertible debentures (which will now be converted into equity and sold), and they have sold a 2.1% gold stream and most of the silver output for another $100 million.

The Buriticá project is anticipated to produce 250,000 ounces of gold over 14 years at an all-in cash cost of US$600 per ounce, which is very cheap relative to most gold miners. If one believes these numbers and ignores all other costs, that works out to US$225 million/year in gross profits at an expected gold price of US$1,500/ounce.

Of course, things are never that easy. Projects remain at the 90% completed stage for a very long time, there are cost overruns, things never run as expected, etc., etc. I’m pretty sure after this acquisition closes that the new owners are going to get a “oh by the way…” reception before the predecessor management bolt out as quickly as possible with their new-found fortunes.

But I was thinking, if this company can receive a $1.7 billion enterprise value for a gold mine project that isn’t even operating, but is expecting 250,000 ounces of a gold in production next year, how come Gran Colombia Gold (another Colombian gold producer) with its 233,000 ounces of production is trading at about a $300 million EV? GCM’s all-in sustaining costs are much higher – around $950/ounce, but at least they’re pulling gold out of the ground. Their major mine still has a few years of life left in it, and the drill results they are getting should be able to sustain lower grade production for a few more.

Perhaps smarter minds out there can inform me why there is such a big difference in valuations. I’m still not interested in GCM equity, but relative to CNL’s takeover valuation, GCM stock looks very, very cheap.

Macroeconomics – one reason perhaps why the S&P 500 has been rising

Take a look at the S&P 500 over the past two months:

It is not entirely coincidental this aligns fairly well with the monetary loosening of the next phase of quantitative easing by the US Federal Reserve, which started in September:

Most of this excess capital tends to find its way pumping demand into the asset market. Right now, that demand gets centered around the large capitalization, large liquidity companies, but eventually that demand flows to parts of the economy that still offer morsels of yield.

Just Energy takes a dive

If you were holding preferred shares in Just Energy (TSX: JE.PR.U), you don’t want to be reading this announcement:

Just Energy Group Inc. (“Just Energy” or the “Company”) (TSX:JE) (NYSE:JE) announced today that it has amended its senior secured credit facility to increase the senior debt to EBITDA covenant ratio from 1.50:1 to 2.00:1 for the third quarter of Fiscal 2020. In addition, the Company has amended the covenants on its senior unsecured term loan facility to increase the senior debt to EBITDA covenant ratio from 1.65:1 to 2.15:1 for the third quarter of Fiscal 2020. Both changes are effective only for the third quarter of Fiscal 2020 and the covenants will revert to the prior levels following December 31, 2019.

In connection with the amendments, the agreements governing both facilities have been changed to restrict the declaration and payment of dividends on the Company’s 8.50% Series A Fixed-to-Floating Rate Cumulative Redeemable Perpetual Preferred Shares (“Series A Preferred Shares”) until the Company’s senior debt to EBITDA ratio is no more than 1.50:1 for two consecutive fiscal quarters. Accordingly, the Company is suspending, with immediate effect, the declaration and payment of dividends on the Series A Preferred Shares until the Company is permitted to declare and pay dividends under the agreements governing its facilities. However, dividends on the Series A Preferred Shares will continue to accrue in accordance with Series A Preferred Share terms during the period in which dividends are suspended.

Preferred shares proceeded to trade from $17 the day before to closing at $9.88, a 42% drop. The common stock, which paid out its last dividend in June 2019, traded down about 16%.

I did remark about Just Energy on September 1, 2019 that “Balance sheet is a train wreck, company is exploring a recapitalization, and the business model itself is highly broken. Good luck!”, but specifically, their big problem is this:

About $222 million is due for refinancing in the year 2020, with the lion’s share the first-in-line secured credit facility that has $203 outstanding.

It is pretty evident by the covenant amendment that the third quarter expectations (noting that Just Energy has their fiscal year-end on March) is not going to have a good quarter. They’ve bought themselves a little bit of time to negotiate with the senior secured creditors, but suffice to say, this one is trading low on all fronts (common, preferred and debentures) for a good reason – a recapitalization is probably in order.

In general, I’m not shocked that the market was valuing the yield on a financial product of a company that is in such precarious financial condition quite highly; the chase for yield blinds most individuals as the underlying framework as to what makes yields possible – cash flow and no imminent liquidity crises. These sorts of decisions that companies make are relatively foreseeable and why I do not have them in my portfolio.

The convertible debentures (TSX: JE.DB.C, JE.DB.D) came up on my radar today as a result. The company cannot suspend their semi-annual interest payment without it being an event of default, but right now the most likely outcome appears to be an equity conversion, and this is under the assumption they can come to some sort of arrangement to placate their senior secured creditor.

The most interesting part of this all is that the company also has a tranche of unsecured term loan facility (8.75% maturing on September 2023) which is partially guaranteed by a director: “On July 29, 2019, the Company drew US$7.0 million from the second tranche and US$7.0 million from the third tranche. These draws were secured by a personal guarantee from a director of the Company.” – this would certainly give this director an incentive to seeing the company not default on it!