Toyota Motors Company – Will not touch

Anybody having common shares of Toyota Motors may think they are purchasing to be a “contrarian” with all of the allegations flying around with respect to their accelerator pedal and perceived safety issues of cars. Looking at a 5-year stock chart, one might think they are catching the lows (currently $77/share)…

… but what really is the upside to an investor? I recall during the ramp-up in oil prices and the downfall of GM and Chrysler (2007-2008) that analysts were jumping all over themselves to compliment Toyota and implying the company is destined to greatness.

Auto manufacturing, at least at the low end consumer market, is a very competitive business and margins are very tight. When companies like Toyota have to end up recalling millions of vehicles because of a politically-motivated examination of perceived safety flaws of their vehicles (I am of the opinion that it is far more likely that for most part the company did not design a ‘flawed’ vehicle), it will affect their market capitalization far more than the recent 15% haircut their stock has taken. They are more likely to head down than up.

I have written this without doing a shred of financial analysis on the company – Toyota stock is being psychologically valued at this time by the marketplace, not financially.

Music to a bondholder’s ears

I own some long term debt in Sprint. Recently, the following was quoted from their CFO:

NEW YORK (AP) — Shares of Sprint Nextel Corp. rose Monday after Chief Financial Officer Bob Brust told investors the telecommunications company plans to pay down its debt and continue to strengthen its balance sheet.

“(In) the next 30 months, we have about $5.2 billion of debt coming due. Right now we plan to pay that as due, not refinance,” said Brust at the Raymond James Institutional Investors Conference, according to a transcript.

The only other better news that could come out of his mouth was that they would be raising capital through the equity markets to pay down more debt, but I will settle with this. Sprint has negative net income, but they have strong positive cash flows, and I think their debt is still (slightly) undervalued. It is my second largest portfolio component.

The only issue I have with their debt is not their ability to pay it off – it is the more macroeconomic perspective of rising interest rates and a US government that is seemingly destined to inflate its way out of its fiscal situation.

Davis and Henderson purchase – Corporate conversions from income trusts

Income trusts are starting to announce conversions to corporations and the effects on their unit/share prices are quite telling. For profitable companies, they will have to announce distribution/dividend cuts to compensate for the effect of the upcoming tax on trust distributions.

Davis and Henderson is a business services company, doing about $482M in revenues for 2009. They are primarily an acquirer and consolidator of smaller companies and they have been fairly good at streamlining synergies with these acquisitions. Their balance sheet is messy (negative $235M in tangible equity, little cash and about $200M in revolving term loans as debt) but they generate hefty cash flows. They also distribute, just like most profitable trusts, the vast majority of their free cash flow. However, they pass my ‘trust test’ which is that they generate more in net income than they distribute in cash.

They announced that they will be converting to a corporation and with it their distributions will be going from $1.84/unit to $1.20/share in 2011 because of the tax impact. This is a 35% reduction in distributions and they rationalized the 64 cent cut by saying that had they been a corporation in 2009, they would have had to pay $0.60 to $0.66 in taxes. Their communications person must be a good spin doctor since they didn’t mention that the projected tax would effectively have to be paid on a larger income amount than $1.84/share – after backing out the intangible amortizations, the company generates about $2.27/unit in cash and a 28% corporate tax take is appropriate. In addition, the corporate tax rate will be dramatically decreasing in Canada in 2010, 2011 and 2012. In 2011 it will be 16.5% federal, and roughly 11% provincial, while in 2012 it will be 15% federal and roughly 10% provincial in the major jurisdictions (BC, Alberta, Ontario).

The point is that the distribution cut is going to be more than covered by the company’s cash flows, and they can use the surplus to pay down debt and reduce leverage on their balance sheet.

I know how a lot of retail investors think, and whenever they see a dividend cut, they will panic and sell. So that, they did:

Trading instinct is a difficult thing to describe, but since I’ve been stalking Davis and Henderson for quite some time now, I knew this would be a good time to pounce. When examining their release and annual report, I estimated investors will take down the stock between 5-15% for the day, so I layered an order to buy shares continuously between 6-12% and got enough of a fill to get a 3% position in the company – I was prepared to take 6%, so this was better than nothing. The low for the day was 8.8% below the previous day’s trading price. As you can see, institutional investors and myself likely cashed in on the retail panic.

People that are not in the upper tax bracket can receive Canadian dividend income virtually tax-free. Starting in 2011, I will be getting about 7.6% “tax-free”, and this should be a sustainable yield on my investment given the financial state of the company and the relatively boring businesses they are involved in. The largest risk to this company (other than the slowdown in the business services they are involved in that will exhibit a natural decline, such as cheque-printing and processing) is rollover risk of their $200M term loans. They can equitize the debt with about 19% dilution to existing holders and the history of the company suggests that their relationship with the banks are stable and it is unlikely we will see an attack on their equity by hedge fund artists that want to bet on a recapitalization.

With Rogers Sugar being my other major equity holding, they are due to announce what they plan on doing with their corporate structure. As it is likely they will be contemplating the same thing, investors would be wise to look at trusts that are planning conversions and seeing if they can realize short term trading opportunities. I know that in 2011 the structure of my registered accounts will be looking different since I want to move dividend-bearing securities outside the RRSP because dividend income will be virtually tax-free.

Federal Budget 2010 – brief thoughts

The budgetary cycle this year from both the federal and provincial government can best be described as “nothing changing, we are staying the course”.

The federal government, in particular, managed to crunch 424 pages of relatively little of political substance in their budget document. A lot of the documentation (as always) discusses the fiscal outlook which is interesting from a macroeconomic standpoint. In terms of government operations, the summary table, as follows, is what one really needs to look at:

Once you remove the effects of the stimulus package, spending continues to increase at a slow rate. This rate is actually a faster rate of spending when you compare it to the equivalent in the 2009 budget (the tables are different sizes in the documents so you will have to click on this image to see the numbers more clearly):

It is obvious that the non-action is highly political – if the government decided to slash and burn spending and government programs, the opposition would likely topple the government and force an election about “providing government programs to Canadians”. In a minority government, the status quo is the safest political approach, to the detriment of the rest of the country. It is only until a clear majority of the public and/or the Liberal opposition starts calling for real spending cuts (compared to the Mickey Mouse “we made tough choices” line given by the Finance Minister) will it be likely that we will see less largess in the present government.

Some commentators have noted that the government is heavily depending on revenue increases to balance the budget in 5 years (which is such a far-off time horizon that nobody will be kept accountable for this plan) – I think the revenue ramp is actually reasonable, not aggressive but not conservative either. It really depends on whether companies will start to hire people, but considering the government sees the big picture with respect to investment capital and corporate tax rates (which, federally, will be dropping from 18% to 16.5% in 2011 and 16.5% to 15% in 2012), this, combined with a reasonable stability in commodity markets, should help the country get back on track economically.

The last note is that interest rates will have a large effect on the bottom line – however, the government has assumed an accounted for a 3-month T-bill rate of 0.7% for 2010 and 2.4% in 2011, both reasonable projections.

“Wait and see” seems to be the message for this budget. It has been the least exciting budget so far in this government’s administration, but this is probably a good decision given the political constraints in the House of Commons. I am not happy with the huge expense ledger, however.

First Uranium gets whiplashed

I have written earlier about First Uranium’s woes – they had an environmental assessment permit that was critical to their business venture pulled.

Today they announced that they have it back.

This is what I was referring to the political instability risk concerning investing in companies that have major operations overseas – judging how burdensome the local government is very difficult unless if you are living there and have a “feel” for them.

First Uranium equity today jumped by 39% and closed the day at $1.81/share. This gives them a market capitalization of $300 million. Before this fiasco began, their equity was valued at about $2.50/share. I suspect their equity is under-valued, but I am not interested in the equity – I am interested in the debt. The equity still has other risks (dealing with governance, management compensation, composition of the near-majority shareholder, etc.) that I am not interested in taking. In addition, there still is the operational risk of actually being able to get the gold refining project up assuming anybody wants to finance the operation. The operation will likely be financed with some combination of equity and debt. Future dilution is something equity holders will face, but this is already baked into the relatively low share price.

The debentures are trading at bid/ask 68/71. Now with their business prospects significantly enhanced (providing that they can raise $100 million of capital that would be require to get the project going), I believe there is a material chance that these debentures ($150M par value) will be paid off at par in 2.3 years to maturity. I am guessing that once the project gets established and the revenues come in as projected (which will be substantial) that sometime in 2011 or early 2012, the cost of capital for the company will be considerably lower and I will get paid off at par. At 69.5 cents, the debt has a 23% annualized combined yield-capital gain for an acceptable risk.