Yellow Pages’ peculiar share buyback

Yellow Pages (TSX: Y), a long-time holding of mine, announced their second quarter results a couple weeks ago.

There were some interesting highlights involved, namely that this quarter was the first quarter in a very, very, VERY long time where they had a sequential increase in revenues between quarters (albeit, the profitability of such revenues decreased as the mix had more lower margin revenues). This got very little recognition.

The actual cash generation figures have still been quite healthy, although this is the first full year where Yellow’s tax shield has whittled away to only partially offset their income. By virtue of making some seriously questionable past acquisitions (before the belt-tightening regime of the existing management) they are allowed to deduct a declining balance amount on their cumulative eligible property, which is better than nothing.

However, the highlight is what is essentially a forced share buyback:

The Board has approved a distribution to shareholders of approximately $100 million by way of a share repurchase from all shareholders pursuant to a statutory arrangement under the Business Corporations Act ( British Columbia ). The arrangement will be effected pursuant to a plan of arrangement which provides that the Company will repurchase from shareholders pro rata an aggregate of 7,949,125 common shares at a purchase price of $12.58 per share, which represents the volume weighted average price for the five consecutive trading days ending the trading day immediately prior to August 5, 2022.

The proposal requires 2/3rds of the shareholders to approve, but they already have consent from the three major shareholders (GoldenTree with 31%, Empyrean with 24% and Canso with 23%) to proceed. Minority shareholders (such as myself) are along for the ride, although because the buyback is proportional, no entity will have a different level of ownership after the transaction (restricted share units, options, etc., typically have clauses to reflect such special distributions).

At the end of June 30, Yellow had 26,607,424 shares outstanding. This works out to a distribution of $3.76/share.

The way I understand it, instead of the entire amount consisting of an eligible dividend, it will effectively amount to a sale of 30% of the stock, which means that the cost basis of such shares can be deducted against the proceeds of the sale (for most people, this will be a capital gain). If my understanding of the tax treatment is correct, then the tax burden of such a distribution will be significantly less than the typical special dividend.

However, in the letter to the three top shareholders, the following paragraph is in there:

The Company agrees that it shall designate the full amount of any dividend deemed to arise under the Income Tax Act (Canada) as a result of the acquisition of the Common Shares pursuant to the Arrangement as an “eligible dividend” pursuant to subsection 89(14) of the Income Tax Act (Canada) and the corresponding provisions of any provincial tax legislation pertaining to eligible dividends.

As those three entities own more than 10% of the common stock of the company, such a distribution would be tax-free if given to their CCPC subsidiaries if classified as such. I am not sure whether differential tax treatment is permitting. When the company’s management information circular comes out, reading the tax opinion will be educational as I have never encountered this ‘forced buyback’ in my investing life.

The bite of inflation is hitting commodity companies

All of the resource companies that have reported to date are guiding costs upwards, due to inflation.

For instance, Teck is now guiding unit costs on copper up approximately 6%. Their major capital project at the moment (QB2, a massive copper project which is nearing completion) just ramped up their own costs once again and is signalling that production will not begin until early 2023 instead of 2H-2022 as expected.

Cenovus’ 2022 projected capital costs are going up 10%.

The rest of them will be roughly similar to this – rising costs everywhere.

The impact of inflation will be permeating through the entire economy. Just because companies are going to be making good cash on a high commodity price environment does not make them immune on the cost side.

Commodities are a price-taking industry, the producers more or less sell at whatever the market is willing to give them.

Companies that are price-making (e.g. SaaS like Microsoft) have a lot more power in this environment, but there is an element of elasticity depending on exactly what you’re selling. Those companies that have wide moats will do very well in an inflationary environment.

Real vs. Nominal GDP

When inflation was at 1-2%, the mental adjustment from nominal to real GDP was pretty simple to calculate. If nominal was above 2%, it means you got growth. If it was between 0-2%, you got negative real growth. If it was below 0%, there would be a media panic about the end of the world.

Now with inflation at 8.1%, a nominal growth of 4% might sound good in ‘ordinary times’, but today is deeply negative on the real end. Since almost nobody is getting 8.1%+ wage increases, it means everybody without hard assets are falling behind in relative purchasing power terms.

If we get a 2% real GDP print, with the current CPI rates, it means things increased 10% in nominal terms. Just think of all the extra tax revenues that come out of this (although CPI-linked expenses will also rise, accordingly).

There is also the impact of capital gains taxes to consider. Say you purchased an asset for $100 last year, and today it is $108.10. While you made $8.10 in nominal terms, in real terms, your investment is still worth exactly the same as it was when you purchased it. However, when you go and dump the investment, you owe the government another $1.08 in taxes at Ontario’s highest marginal rate, so you’re actually sitting in the hole. You needed a 11.1% nominal return to ‘break even’! Compounded annually, inflation is a gigantic tax vacuum for the government – and whether you like it or not, we are all paying for it.

The differential in numbers from old times is significant. It will also have the impact of making financial statements from previous eras less comparable.

Effectively, if we string together 5 years of 8% inflation (I’m not saying this will happen, just for illustration), this produces roughly a 50% distortion from real to nominal statistics, comparatively speaking.

Needless to say, this is also very convenient for historical long-duration fixed debt issuers, namely the government. Returns on short-term government debt are still very poor (326bps for 1-year money as I write this, in nominal terms!) in relation to the erosion of purchasing power.

An poker analogy to this is higher inflation means that the casino (government) is taking more rake off the table for each hand. We are all forced to play this economic poker game, but with inflation, the ability to win net amounts of money decreases as the take rises. The big losers are those without assets – their purchasing power continues to erode.

Interest rates will tell the story

It is well known that inversions in the yield curve signal bad economic times coming ahead.

Why? Typically credit is extended by financial institutions that make their money by borrowing short and lending long.

When the yield curve is inverted, financial institutions will find it more difficult to make money since the interest spread capture is narrower.

JP Morgan, for example, has announced in their last quarter that they are suspending their share buyback program. Their politically correct wording was: “In order to quickly meet the higher requirements, we have temporarily suspended share buybacks which will allow us maximum flexibility to best serve our customers, clients and community through a broad range of economic environments.”

Just remember, they’re suspending share buybacks for your safety!

Certainly when JPM is deciding to go into capital preservation mode, I get suspicious. Indeed, when I look at the Canadian banks, I think most of them have a good chance of going back to the pre-Covid levels. Second-grade financial institutions (e.g. Equitable, Home Capital, etc.) are offering GIC rates of around 4.4-4.5% for two-year money, which is the highest I’ve seen in a very long time. If they have to pay that much for their short-term capital, good luck on the duration match when they are also charging 4.59% rates for a 5-year mortgage!

Presently, I’m looking at one of the weirdest interest rate outlooks I have ever seen. The markets are predicting an increase on the July 27th Federal Reserve meeting, and another rate increase in September. However, in 2023, rates are expected to drop again, presumptively modelling this economic slowdown and recession nearly everybody and their grandmother is talking about at this point.

It is the oddest recession on the planet where you have low unemployment rates (5.1%, which is about as good as it gets here), commodities are booming, governments are raking in record corporate income taxes, etc, etc.

The Canadian rate curve has a similar trajectory – September 2022 3-month Bankers’ Acceptance Futures are trading at 3.85%, while a year later (September 2023) they are at 3.30%. Right now that rate is at 3.18%.

Since this rise in rates in 2022 and the drop in rates in 2023 is all baked into existing futures pricing, it leads one to the question – where might this actually go?

A few scenarios:

1. We get our recession, but inflation persists – banks likely have to stand pat on a relatively low rate of interest (2-2.5%) and real rates will continue being negative for the foreseeable future.

2. We get a massive recession (e.g. the asset deflation scenario with QT and everything), inflation busts out due to demand evaporation (supply chains normalize, etc.) – banks will crank rates down likely to the zero bound and you can dust off your post-Japan 1989 playbook for another couple lost decades.

3. The economy is actually fine, capital gets invested, etc. – rates will steady and possibly rise even further as this would probably be inflationary in the short-run.

Since a lot of the inflationary phenomena involves psychological expectations, it is very difficult to predict how this is going to resolve itself.

Cash (take a mild amount of duration risk for a net 370bps YTM with TSX: XSB!) might be trash, but it might be less trashy than the alternatives. Perhaps taking the real rate loss and being able to purchase assets for 20-30% of a discount from present is a possible scenario for those that are patient. Quantitative tightening has just barely begun and the typical real world economic impacts of interest rate increases will take a year to permeate – we’re now four months from the initial March 2, 2022 quarter point increase. Perhaps when the collective amounts of all of the Covid handouts have been spent, there will be a significant belt-tightening process. There are many lines of speculation about the future.

2022’s second quarter results will be great, but watch out ahead

While looking at the red ink that has accumulated in my portfolio, I’ve been doing some deep thinking lately. The story is not going to be that good.

In the fossil fuel world, the second quarter results are going to look really, really good from a cash flow perspective.

I anticipate a speculative run-up as a result prior to the announcement of such results. “Buy the rumour, sell the news” is a cliche that has tended to have a better than 50/50 success rate in my investment life.

Indeed, posted metrics will be so ridiculously good that it will attract people/capital that are otherwise only vaguely aware that cyclical industries require a different mindset.

I will use Lumber as an example. It is a commodity that is much more used to ups and downs, and their physical capability has historically been punctuated by start-up and shut-downs that wax and wane with inventory levels and overall demand.

A random example of this would be the Jimmy Pattison-controlled Canfor (TSX: CFP), with my annotations on their earning history and estimated earnings:

You can see on this chart that an astute purchaser would have been able to pick up shares of Canfor at (the Covid crisis peak) half earnings. Yes, a P/E of about 0.5x.

Of course, hindsight is 50/50. Many people (myself NOT included) thought the world was about the end in March 2020. But instead, Covid created a huge boom for the underlying commodity price because of a huge culmination of factors: nobody was producing, inventory levels were already low, the supply chain was wrecked, and demand was increased because many decided that building a deck or doing home renovations in the summer of 2020 was a great idea while everybody was on lockdown.

With retrospect (which would have triggered at the Q2-2020 results), the shares were trading at around $16/share – about the price that Pattison tried to take over the minority shareholders.

The acceleration of lumber pricing continued and eventually the shares normalized at around $28, or roughly 2x earnings, but normalized to 2023’s estimate, about 5.5-6x earnings. Also note how the chart hardly moved despite the “second wave” of lumber pricing from end of Q2-2021 to Q4-2021.

The earnings multiple on a cyclical company is notoriously difficult to predict – whether it is the cash flow, reserves, perceived scarcity, etc., all have a bearing on the multiple the market decides to give.

The actual cash flows that are generated, however, is internal to the company and their capital allocation scheme determines whether shareholders actually receive any monies or not. In the case of Canfor, they repaid some of their debt and engaged in some acquisitions.

Going back to the fossil fuel world, most of the Canadian complex is trading around 5x free cash flow to EV, based off of US$100 oil.

We will be seeing very different capital allocation schemes going forward. Nearly all companies are aggressively paying down debt (Whitecap is the big exception), and some are engaging primarily in dividends as a return mechanism, while some are choosing buybacks (looking at MEG Energy), and some are engaging in a hybrid approach. Investors can align their approaches to capital allocation with the managements of the various companies out there, in whatever blend they so choose. For instance, I like where Cenovus (TSX: CVE) is going, by spending cash flow to concentrate their ownership in their assets, running them well, having an integrated production and refining business, keeping a modest debt level, and then balancing out buyback/dividends. It’s a good all-in-one stock.

However, all of this might be overshadowed by one gigantic blade over the necks of the market, and that is central bank monetary policy.

Central banks are clearly in panic mode. There is a “real” component to inflation, but the “psychological” component of inflation, just like in the marketplace, is nearly as relevant. Take a look at the Home Capital Group (TSX: HCG) fiasco half a decade ago for a good example how psychology is very relevant in markets.

The theory is simple. If people believe that inflation will be higher for longer, their behaviour will be changing in conjunction with the expectations. Wage demands will increase (a good example of how this is playing out is the upcoming strike with the BC Government Employers’ union where the government offer vs. the union demand is way out of line – who the heck wants to take a 3% increase in wages when CPI is printing at 8%????). People will be spending more money today than tomorrow because the rate of interest they receive for their capital is lower than the posted CPI rate. It is like a milder version of Argentinian economics, where you discover when you go to the grocery store to buy a bundle of toilet paper, that you can only buy one roll instead of a package because the storekeeper knows that the toilet paper bundle can be sold for more just by waiting.

At a certain point, it doesn’t matter whether the actual money supply is contracting (or at least holding flat), and it doesn’t matter whether the supply chains are restoring, and it doesn’t matter how much crap gets stuffed on the shelves of Costco, Walmart and Target – if the psychology is in an inflationary mindset, it is very difficult to shake off.

This is why central banks, in theory, are regarded as independent entities, and generally are regarded as knowing what the heck they are doing to keep inflation in check (their sole mandate). They are the ones to adjust the monetary levers accordingly to keep the currency relatively level, and this stability generally breeds confidence that businesses need to make long-range spending plans.

This confidence has been badly shaken over the past couple years. First, there was “no danger of inflation”, then it was “transitory”, and now of course it is full-blown “Oh ****, we really screwed this up and really have to fix things” mode.

Ordinarily all it took for central banks to have their desired effect was to talk big – because people took them seriously and with authority, central banks could talk market expectations in a particular direction.

But now their credibility has been shot and they’re desperately playing catch-up, not on interest rates, but rather to restore their credibility. This is probably the reason why we got a 100bps increase instead of a widely-expected 75bps.

The Federal Reserve might mirror this increase in the July 27th fed meeting announcement (right now the August Fed Funds Futures are a “lock” at a 75bps increase).

However, will this be enough to shake the psychology of increasing inflation? People normally associate fiscal competence with the elected bodies (in this case “I don’t think about monetary policy” Trudeau and “mental lapse” Biden), and confidence in both are at very low levels. Despite posting record revenues (especially as they are nominal and not real dollars), governments are still posting deep deficits. As they are heavily indebted, as they roll over their bond books, they will be paying higher and higher interest expenses out of the fiscal end.

At this point, the central banks at this point have little choice other than to keep increasing interest rates until they have broken the psychology of inflation expectations. I had argued in a prior post they had to “surprise”, and the Bank of Canada judged that going 25bps over a widely anticipated 75bps was a sufficient shock. I will claim it is not enough.

Currently, we have the expectations showing that 2022 will feature a few more interest rate increases (say to 3-3.25%) but in 2023 there is an expected easement of rates, in anticipation of a recession.

The question is whether this is sufficient to break the psychology of inflation expectations. I don’t believe it will, at least over the next half year. Just looking at the price of energy, there is still going to be higher year-to-year pricing of commodities going forward until probably February 2023 – while inflation may simmer, it will be nowhere close to the 2% target level – noting that inflation is measured as a year to year comparison.

This means in order to quell the psychology, rates needs to rise even higher, and this will surely initiate huge economic troubles going forward – a deeper recession than most people probably will figure at this point.

This does not impact North America only – it affects most of the world economy, where US-denominated transactions dominate foreign trade contracts, and when the US dollar is as strong as it is, it acts like a 16 pound bowling ball ramming through the economies of the world as they desperately seek US cash – which explains the state of the Euro, Yen and other third-world currencies.

Canadian currency has somewhat of a buffer because of its trade links with the USA and commodity exposure, but if the world economic picture erodes to the point where energy consumption declines below the supply levels, surely fossil fuel commodity prices will drop and this will not be good for Canadian currency.

Also, with the rise of interest rates, both floating and fixed rate mortgage payers alike, especially for those that purchased properties in the past couple years, will be causing a lot of financial stress in the market. Your typical 25-year amortization mortgages that are up for renewal will also be paying more on this credit cycle, and perhaps people over-leveraged will be forced to sell properties. If the projected interest rate increases go higher than expectations, this will surely create some scenarios where you may see financial institutions that specialize in non-insured mortgages see financial stress and this will create more ‘interesting times’ financially.

Ultimately this depends on reading the psychology of the masses, definitely an art and not a science.

It is incredibly difficult to foresee how this plays out other than to be aware of the scenario. All I know is that caution is warranted. Especially nearing the end of this year, we might see a situation where a lot of good-quality equities out there are going to get flushed down the toilet both for tax-loss selling reasons and also because liquidity is tightening up so badly (interest rates plus QT) that players are forced to reduce leverage.

Cash is the only defense in this scenario. Everything else (gold, bitcoin, commodities, corporate debt) will take a dive, with perhaps the exception of short-dated government debt.

However, there is likely to be a “bull-whip” effect if there is such a flush-out, where those extraordinary circumstances that initiated a panic selling will likely lead to impressive gains going forward. Now is the time to compile companies on your watchlists that will likely survive the upcoming carnage.