Dream Unlimited Preferred Shares

With the calamity hitting the preferred shareholders of Dundee Corp (of which I narrowly escaped), I have long noticed that their spinoff corporation, DREAM Unlimited (TSX: DRM) has a similar situation going on with their own preferred shares.

You will have to dig through SEDAR and look for a May 31, 2013 document that is 8783kb in size and go to page 60 of 141 in the PDF document for a legal definition of what these preferred shares are. They made it so convenient as the documents are not even made searchable with the usual control-F function on Adobe Acrobat.

They trade as DRM.PR.A and they are retractable by the corporation at $7.16/share, and redeemable by the shareholder at $7.16/share, in both cases with accrued dividends (7% coupon on a $7.16 par value). Redemption and retraction are given with at least 30 calendar days of notice.

Unlike Dundee Corp, there is no ability for DREAM Unlimited to sneak a shareholder-hostile proposal to scrap the redemption feature without a significant sweetener – if they did so, you can “vote” by exercising your redemption rights and get your money 30 days later instead of voting your shares against such a hypothetical proposal.

The only risk is the underlying corporation, DREAM Unlimited, elects to pay the redemption with common shares. The provision is 95% of the typical 20 day volume weighted average price scheme that is common to a lot of other offerings out there, or $2/share if this is the higher price. DREAM Unlimited common shares are trading at $7/share and with a market capitalization of $526 million, so a dilution of $36.7 million is not going to hammer the common shares below $2 if they tried an equity redemption – you’d likely be able to get out above par value in such an instance. The underlying business is not prone to “gap risk” (i.e. this isn’t some biotechnology company that will drop 70% one day due to a failed clinical trial), but it is in real estate development – this means that any of their properties that are not in Alberta or Saskatchewan, should be relatively stable (at least until you can get your redemption money in 30 days time).

In typical Dundee fashion, however, while the corporation is reporting considerable GAAP profits, their cash flow statements leave much to be desired. They do have ample liquidity in the meantime, having negotiated a $175 million million first-line facility with the banks expiring June 2018 and also $200 million of spare capacity on their operating line of credit which expires on June 2017. There is easily enough room to pay for a redemption of preferred shares – indeed, the fact that the preferred shares occupy a $36.7 million hole on their balance sheet probably forces them to be more conscious about this liability. I wonder why they haven’t even just bitten the bullet and redeemed this expensive capital.

In other words, the market value of this preferred share issue is going to be anchored around the $7.16/share mark as investors are able to skim off a 7% eligible dividend until such time the corporation bites the bullet and finally redeems the shares. If it goes too below $7.16, it is an easy arbitrage to buy below $7.16 and instantly redeem if you believe there is any sense of credit risk. It is as close to a risk-free 7% as it gets.

I note that the preferred shares were trading as low as $7.00 today and this was likely fueled by some investor out there getting his RBC Margin account spontaneously liquidated – it wasn’t a trivial amount either, around 40k shares worth. About 30,000 of them traded at $7.00 and somebody redeeming them back to the corporation at $7.16 made the easiest CAD$5000 on the planet. Ordinarily DRM.PR.A is not an actively traded stock and with all of the stress occurring in the marketplace, what may be “risk-free” isn’t as liquid as cold hard cash!

Anyway, I bought some shares at $7.00 today.

Revisit of Bombardier

There was an article on the Globe and Mail regarding my declaration that I had invested in Bombardier preferred shares (TSX: BBD.PR.B / BBD.PR.C).

I’m going to look very smart or very stupid at the end of this ordeal.

I will emphasize this is a high risk, very high reward-type opportunity. With high risk goes the chance for permanent capital loss, so the position size is appropriately small.

At current market prices, BBD.PR.B trades at a 12.6% yield, while BBD.PR.C trades at a 16.5% yield.

Other than the obvious business execution risk entailed within their aircraft division (specifically the execution of the C-Series project), there is another huge risk for investors: they will suspend preferred share dividends.

If this happens, BBD.PR.C will trade significantly lower (percentage-wise) than BBD.PR.B. The conversion risk is another component of the yield differential.

The comment about bond yields was accurate as of the middle of November, where after the government equity injections the short-term maturity bonds traded at reasonable yields. Today, however, yields have significantly widened, which also accounts for why the preferred shares are trading at such blowout yields.

Below is a graph of various yield to maturity curves of Bombardier debt (note these are NOT “yield to maturity” curves, I use a current yield + capital gain calculation which is non-standard but a more intuitive measurement for high yield debt I prefer using):

2015-12-14-BBDBondYields

The near-term maturities have risen to the 10% yield levels, which puts the corporate entity in the refinancing danger zone.

Considering how much equity was injected into the company (US$2.5 billion) over the past few months, this is not exactly an enthusiastic market for debt, especially their March 2018 issue which matures in just 2.25 short years from now (albeit this specific issue’s last trade was 98 cents on the dollar – but go back another 6 months and that one traded at 90 cents!).

Part of this is likely because of year-end dumping for tax reasons, and the embarrassment factor of any fund managers that are holding onto this – they don’t want those shares to appear on their year-end financial statements to clients!

However, there is also a very deeply political component to my investment thesis. The Quebec investments are part 1 of the story. I’m waiting for part 2 to resolve itself (and this does not involve a federal government investment – if it happens, it will be icing on the cake).

The point of maximum fear

Very interesting things happens to markets at bottoms and tops – there are typically panic spikes down and up.

My market instincts suggest that we’re approaching some sort of local maximum for fear in terms of the energy markets. All doom and gloom, and usually you hear about the opposite arguments (demand is rising, geopolitical risk, etc, etc.) but none of this is present.

Probably a reasonable time to shop for assets in entities that will be able to survive the trough.

Dundee Corporation – DC.PR.C – Series 4 Preferred Shares – Exchange Proposal – Analysis

Dundee Corporation (TSX: DC.A) has a preferred share series, Series 4, which trades as TSX: DC.PR.C. The salient features of the preferred share is a par value of $17.84, a 5% coupon, and a shareholder retraction feature which enables the shareholder to put the shares back to the company at par on or after June 30, 2016. The company has the right to redeem the preferred shares at $17.84 in cash or 95% of the market value of DC.A stock, or $2/share, whichever is higher.

I was going to wait for the management information circular to be released before definitively writing about this proposal, but my impatience got the better of me (in addition to me no longer being a preferred shareholder, which tells you what I think of the arrangement). James Hymas has written twice about this one (Link 1, Link 2) and his conclusion the was the same as mine when I read the arrangement: we both don’t like it.

Dundee announced they wish to change the terms of the preferred shares per the attached proposal as they do not wish to allocate what would functionally be a CAD$107.4 million cash outlay, puttable at any time by the preferred shareholders. The special meeting will be held on January 7, 2016 with the record date at December 3, 2015 (so shares purchased until November 30, 2015 are able to conduct business at the meeting with the typical 3 day settlement period).

Details of proposal

(ranked in my order from most important to least important)

1. Shareholder “put option” can only be exercised on June 30, 2019 (from the present date of June 30, 2016);
2. A consent payment for an early “yes” vote of $0.223 (one quarterly dividend coupon payment) and $0.1784 for the broker holding the shares!
3. Coupon goes from 5% to 6%;
4. Company will have redemption features above par (and at par at June 30, 2019) that realistically will not be triggered;
5. A “reverse split” at a ratio of 17.84/25 to adjust the par value of the preferred shares to $25/share making the math a little simpler;

The required vote is 2/3rds of the voting shareholders.

Analysis

Dundee Corporation is controlled by the Goodman family in a typical dual-class share structure. The corporation is a quasi-holding structure, with entities that are consolidated on the financial statements and some that are accounted for with the equity method. Thus, reading the income statement of the consolidated entity is not a terribly fruitful activity until one looks at the components. Most of the significant components are losing money. Considering that there are some heavy investments in oil and gas, and mining, this is to be expected. The best income-producing asset is the spun-off Dream Unlimited (TSX: DRM) which is a real estate development company. The take-home message is that the corporation as a whole is bleeding cash – about $25 million a quarter in 2015 to date.

Their balance sheet is not in terrible condition, but it is deteriorating – At Q3-2015 they reported $274 million in consolidated cash in addition to having a $250 million credit facility (with $93 million drawn) that expires in November 2016. However, most of the other assets are related to their heavy investments in the resource industry, which already received an impairment charge in Q3-2015, and likely to be impaired further.

So while it is very evident that Dundee will be able to pay their CAD$107 million preferred share liability when it is available to be redeemed on June 30, 2016 and beyond, the clause to extend the redemption date from June 30, 2016 to June 30, 2019 involves a pricing of significant credit risk over the incremental three year period, hence this deal being very unattractive for preferred shareholders – it is not entirely clear that the company will have any cash left to redeem the shares! The company does have the option to redeem the preferred shares in common shares of Dundee, but at this point the common shares might be worth under the CAD$2 threshold which is the minimum conversion rate.

Finally, the market does have valuation information on the other preferred share series trading – DC.PR.B and DC.PR.D – currently giving a 9% yield with no redemption possibilities – and this would suggest that the proposal of DC.PR.C, assuming a moderate “redemption” premium (i.e. with the shareholders receiving their money back in 3.6 years), would result in such shares trading at a minimum of 92 cents on the dollar, or roughly CAD$16.41 equivalent on today’s preferred share price (roughly a 4% price reduction on today’s CAD$17.00 trading price!). This assumes that there is equal “credit risk” with non-payment of dividends between now and the redemption date and no risk of receiving a lessened payment in 3.6 years – hence, 92 cents on the dollar would be a maximum valuation at present given market conditions.

Thus, the consent payment would need to be significantly higher than $0.223/share for preferred shareholders to be compensated for the extra three years of “holding risk” they are taking – my minimum estimate would be about $1.43/share for this to even be considered on par value, or $0.60/share when considering the existing market price of CAD$17. Taking the mid-point of this would be a $1/share consent payment. I would suggest that $0.60/share cash plus another $0.40/share in common stock be given for such a deal to be accepted. I’d love to see how the “fairness opinion” rationalizes this original deal being fair for shareholders – maybe fair for the company paying for the report!

Ethics

What is unusual about this proposal is that the intermediary (i.e. in most people’s cases, the broker that holds the shares) receives $0.1784/share that is tendered in favour of the deal. This clearly will create a conflict of interest between brokers and their clients. Ironically if that extra $0.1784 were applied to the beneficial shareholder, the proposal might have stood a higher chance of passing.

These tactics are clearly anti-shareholder and a huge red flag against management that would propose such a scheme.

Conclusion

My recommendation is that DC.PR.C preferred shareholders reject the proposal. It needs to be sweetened further.

I did sell all my shares between CAD$17.20 to CAD$17.44 on the open market last week and am happy to be rid of this headache.

For knife catchers only – Kinder Morgan

Kinder Morgan (NYSE: KMI) is in a chicken-and-egg situation. It needs financing to implement capital projects, but the cost of its financing has been steadily increasing due to its financing requirements.

Energy pipeline equities are a staple income producer for a lot of funds out there, but if they have their dividends threatened, the supply dump is going to be gigantic.

kmi

I sense this is a falling knife situation where it will be very difficult to predict the bottom. You can make an excuse for US$16.84/share being the bottom, or you can also make an excuse for US$9/share. It just depends on how many funds are hitting that sell button, irrespective of price.

Cash-wise, it is very evident they will have to cut their huge dividend. They are giving out US$4.5 billion a year and it is completely obvious they cannot sustain it given their capital spending profile (offset with their not inconsiderable positive operating cash flows). Refinancing their debt ($3 billion of it current as of September 30, 2015) is going to be progressively expensive as bond yields rise and their equity price drops. They do have a credit facility with $3.4 billion availability, but their buffer is thin!

I am sure Kinder Morgan will recover this financial earthquake, but how low will their common stock go before they recover?

Finally, let this be a lesson those that invest in highly leveraged industries (e.g. power generation, pipelines, etc.) – you never know when the market will arbitrarily pull the rug on your refinancing program.