First Uranium – valuation

I don’t know why I find the trading of First Uranium (TSX: FIU) to be this exciting, but it is fairly obvious the market is pricing in a turnaround in its operations. Considering that it couldn’t have been managed worse in the year 2009, this is not entirely surprising. FIU shares are up about 60% over the past month. A share price of $1.25 gives it a capitalization of $220 million. The shares will start to face resistance as it cuts into the overhang caused by the secured note issue (which is a $150M issue with a $1.30/share conversion price). Conversion of the notes will result in about 115M shares issued, or about 40% of the company.

Valuing the notes, subordinated debentures and equity is not a trivial process.

The notes currently are not the most liquid product on the planet, with a closing bid/ask of 105/124 cents on the dollar. These notes are also secured by assets and in the event of a default would likely have some sort of recovery. Using the flawed Black-Scholes model, and using a 50% implied volatility (which is an incorrect estimate) gives a 36.5 cent per share value per call option at $1.30, expiring in March 2013. At 105, ignoring the conversion feature of the note, represents a 6.7% current yield and a -2.0% capital loss for the remainder of the 2.4 year term. The actual return realized by noteholders will depend on FIU’s trading price.

Using the 50% implied volatility figure, the option embedded within the notes have a “delta” of about 65%, which means that for every 1% that the equity changes, the underlying value in the conversion feature will change 0.65%. If FIU trades significantly above $1.30/share, the equity portion will dominate the value of the note, while if FIU trades under $1.30, other considerations such as ability to liquidate the assets become more of a consideration. There is no “clean” way of valuing these notes, as you have to separately calculate the fixed income and equity components, despite the fact that both of them are linked!

The unsecured debentures, maturing on June 30, 2012 are trading bid/ask 75/77, and using the midpoint as a reference, the yield to maturity is a whopping 23.0%; or the current yield is 5.6% and capital gain on maturity at par is 18.7%, for a joint yield of about 24.3%. It is likely that if FIU is trading significantly above $1.30 around the maturity date of the debentures that they will be able to refinance them. If FIU is trading under this, then it becomes increasingly likely that the debentures will receiving significantly less – the people holding the debentures can force a bankruptcy, but given their low seniority they will likely not be in much of a position to doing so.

The equity has traded historically as high as $8/share in May of 2009, and the company was very smart to pull off an equity offering near this price (before the shares tanked). Indeed, if this valuation was at all correct, even when you factor in the subsequent dilution, there is the potential to see the operation go for $3-$4/share if everything goes to “plan”. Of course, it has not in the past, and will likely have issues in the future!

FIU’s capital structure is a very strange one to analyze, especially with respect to the profitability of its operations. As I stated before, this is a classic high risk, high reward situation. In no way would anybody be sane to “bet the farm” on it, but a small allocation is in order – which is what I have at present in both the notes and debentures but not the equity. The notes already have enough equity value in them that can take direct advantage of a price rise in equity.

Geopolitical conflict and investing

Nothing introduces more economic volatility in the world than the threat of war.

Today, North and South Korea had a minor skirmish. Normally they have skirmishes once in awhile, but this one resulted in the loss of life from direct land-based artillery shelling, which is different than past skirmishes.

I have been aware of this risk, characterizing it as a “wildcard” in my third quarter report – although I was concentrating on the upcoming Iran-Israel conflict, certainly North and South Korea is another area of the world to look at. South Korea has some very relevant industries that have entered North American culture (for example, my car is a Hyundai, and my laser printer is a Samsung!) and an armed conflict between the two countries would be economically catastrophic, especially for the South.

In terms of the marketplace, other than investing in volatility, an investment in defence contractors may be a hedge against geopolitical risk. In no particular order, the major US defence companies are Lockheed Martin (NYSE: LMT), Raytheon (NYSE: RTN), Boeing (NYSE: BA), General Dynamics (NYSE: GD), and Northrop Grunman (NYSE: NOC). Upon some cursory research, one discovers the valuations of these firms are fairly low.

The reason for relatively low valuations of defence contractors is primary political – most of these companies derive the majority of their revenues from government contracts. With a Democratic-controlled government combined with massive fiscal deficits, one can see why there is a low valuation. Perhaps they are a cheap hedge against geopolitical conflict.

Keep in mind there are small-cap and mid-cap opportunities in the same sector which offer more specific types of exposure, but these typically involve a bit of technology research and knowledge of global military trends.

Watch, but not trade volatility

I have discussed this before, but it bears watching. Volatility is at a relative low point in relation to the past thee years:

The events in late 2008 strictly related to the financial crisis (the downfall of Bear Stearns, Lehman), and volatility remained relatively high through the first half of 2009 before calming down.

The markets reached some sort of complacency in the first quarter of this year, before volatility rose again with the advent of the European (Greek) sovereign debt crisis. This resolved, and volatility is dipping again.

It may lower even further, but traditionally volatility is anti-correlated to index performance – the higher volatility goes, the lower the underlying index. Some people have the misconception that the VIX is predictive; it is not, but it can be used as a barometer of market’s future expectations of volatility.

One might be lead into believing that buying and selling volatility itself, compared to the underlying index, may be the financially wise way of playing this. Unfortunately, it is not so easy – the above chart is equivalent to a “spot rate” on volatility – mainly the volatility over the next 30-day period. There are products that are designed to trade volatility directly (VIX futures), but in order to sustain a position, you must take rollover risk.

For example, if you think volatility is going to rise in December, you can buy the December future. But if the volatility does nothing between now and the December expiry (third Friday in December), you must sell your December position (or settle it with cash) and then purchase the January future, which may have a significantly different price than December.

There is an exchange-traded fund, (NYSE: VXX) which performs the same function (for a 0.85% management expense ratio):

As you can compare with the first chart in this post, there is correlation, but during “dull” moments, the ETF is absolutely destroyed by the rollover process. This is similar to most natural resource ETFs (e.g. UNG) which are also destroyed by traders picking away at the automatic rollover.

Rollover risk is somewhat mitigated by the (NYSE: VXZ) ETF, which uses futures that are dated roughly 6 months in advance, but this has tracking error with existing volatility – current volatility may spike, but the future 6 months out might not track the current action.

There is clearly no free lunch in trading volatility – it is not as easy as looking at the VIX chart and thinking you can “buy” it, thinking you are buying low and preparing to sell high. Almost like options, not only must you get the direction correct, but you must get the timing correct, which is not easy.

Traders might be allured by past price action (e.g. this year, doubling your money buying in April, and selling in May), but your timing must be absolutely sharp. There is no way to determine that buying at 75 and selling at 150 was the proper decision except purely in hindsight.

You can even buy options on VXX, but note that the traditional implied volatility calculation (based on the Black-Scholes model) has little to do with properly valuing options on volatility futures – more so with this option than traditional equity options!

Thirst for yield – FortisBC

Via James Hymas’ daily report…

FortisBC (a subsidiary of Fortis, TSE:FTS) sold CDN$100 million worth of the most mis-named “Medium Term Notes” which, according to the shelf prospectus filing, are unsecured debentures. The yield was 5.01%, a spread of 135bps over government, and the term was… 40 years.

I know utility companies are supposed to be rock-solid stable, but this thirst for yield is becoming a bit too much to handle. Capital is racing to purchase income at any cost. Equity in the master company (Fortis Inc.) at current prices and past 12 months of earnings ($1.60 EPS) is 5.1%, so assuming any sort of natural growth for inflation and rising prices would lead one to suspect that the equity would be the cheaper option, even when you factor the elevated prices for utility company equity. Fortis’ common shares hardly budged even during the peak of the late 2008-early 2009 economic crisis.

Unloading some more long term debt

One of my corporate long-term debt holdings in R.R. Donnelley (NYSE: RRD) has been trading significantly higher since my purchase point in 2009. I had invested in the 6.625% October 2029 debenture, via a trust preferred security (NYSE: PYS), which has a coupon of 6.3%.

Although I had been sitting on large unrealized gains on the issue and was intending to dispose of it in 2011, the trading above 24 proved to be too tempting so I unloaded it and realized gains. Although it’s entirely possible the bonds will continue trading this high in a couple months, I didn’t want to take the gamble.

Mathematically, assuming a continuous yield (which the trust preferreds do not trade as; they trade “as-is”), the PYS security would have a pre-tax current yield of 6.5% and an implied capital gain over 18.9 years of 0.2%. This is below what you can get with some shorter duration fixed income securities, so disposing of this will be a good decision assuming I can deploy capital more efficiently in the future.

The equity in RR Donnelley at this moment appears to look like a better investment than its long-term debt – the company’s cash generation is significant and its debt is termed out properly and has been managed well, so there is unlikely to be a liquidity risk with the operation. Even if you assume they do absolutely nothing but earn income at the rate they have been doing in the past 9 months (a false assumption due to seasonality in their business), the equity will be yielding a minimum of 7.6% at present prices – a compensation of about 1% over debt. When you factor some very conservative growth assumptions, it skews significantly in favour toward the equity relative to the debt.

In terms of overall portfolio movement, my long-term debt holdings have shrunk again and cash has increased. If/when long-term government bond yields start to rise this should prove to be a good move.