Rogers Sugar reports quarterly result

My largest holding, Rogers Sugar Income Fund, reported a solid but not spectacular quarter. What was odd is that they released the result at 1:30pm eastern time, which was mid-day while the market was open. The market hardly blinked and then a couple hours later there was some minor volume at slightly lower prices to end the day.

The debentures (which I do not own) are trading at around 105% of par value both with a yield to maturity of less than 4%; they do not mature until June 2012 [$50M/6.0%/$5.30/unit conversion] and 2013 [$85M/5.9%/$5.10/unit conversion]. They can be called away at par in June 2010 and 2011, respectively, which is possible if they can secure cheaper financing. The debentures could even be converted to equity if the units trade above the conversion price, which is another possibility. Either way, at present, the solvency of the trust is not in question – they have very good access to credit.

I absolutely love the external reporting style of management – they do a very good job walking you through the GAAP numbers, which are contaminated with inflated and deflated numbers as a result of management’s rigorous hedging of input costs. Management then gives you metrics which separate the timing effects of the hedging. They do it in such a way that is simple, yet elegant, and this is presumably a reflection of CFO Daniel LaFrance‘s style. It is also a textbook example of why GAAP is not the be-all-and-end-all of financial reporting – this will equally be true with the implementation of IFRS (International Financial Reporting Standards), another scheme mainly to enrich accounting consultants and make financial statements even more unreadable than they are presently.

The sugar industry is something that I never quite intended on being relatively knowledgeable about, but over the past few years I’ve accumulated quite a bit of information of the industry, at least of how it applies to Canada. The industry is fairly easy to research, which makes the evaluation of management’s ability to keep costs down and be able to make educate guesses on where the marginal risks are critical, which I think Rogers Sugar has done a good job doing.

Rogers Sugar Income Fund (through Rogers Sugar in Western Canada and Lantic in Central Canada) services mostly the domestic Canadian sugar market – there is one significant competitor in Central Canada (Toronto) in Redpath Sugar and there are also fringe competitors such as Sweet Source Packaging in Toronto, which is under the label of Sweet Source Sugar. The domestic market demand for sugar has been very slowly dropping over the past decade, presumably due to industrial usage shifting toward sugar knock-offs (such as high fructose corn syrup and artificial sweeteners), but otherwise is relatively stable. Despite what one sees at Superstore and Costco, the vast majority of consumption is through industrial usage (such as most of the stuff you would see at Tim Hortons).

Because most countries heavily subsidize their sugar industries, there is a high degree of protection in the industry. As a result, Rogers Sugar, Lantic, and Redpath are able to compete primarily on domestic fronts. There is some small volume of competition that will be coming through Costa Rica through the free trade agreement implemented with them, but it should have a small impact on the domestic marketplace. In addition, the USA and Mexico occasionally open up some component of their own domestic marketplace whenever they face domestic sugar shortages – such as when an adversely located hurricane decides to wipe out their production capability.

Most of the input costs come from importing raw sugarcane from locations south of the USA and processing it into granulated sugar products. In Taber, Alberta, Rogers Sugar additionally harvests and processes sugar beets into raw sugar. The primary cost (other than labour) of refining this raw product comes from the energy consumption required to transform the product – which is through natural gas.

A positive change in price of refined sugar will have a positive impact on gross margins for Rogers Sugar, at the expense of cannibalizing some of the marketplace for substitutable sugar products as those suppliers will convert to high-fructose corn syrup. As sugar prices have been at record highs lately, it remains to be seen whether the positive impact on gross margins will be more or less offset by the reduction in sales volume.

Rogers Sugar gives off a distribution of $0.46/unit (9.75% on the current unit price of $4.72), and this quarter is the first time that management has announced that they are looking into alternative structures with respect to the onset of income trust distribution taxation in Canada. Specifically, they have stated:

We are investigating corporate structures as an alternate to our current income trust structure. Whether we convert to a corporation and as a result pay corporate income taxes or continue with our income trust structure beyond 2010 and become subject to distribution tax, we currently anticipate paying dividends or distributions at levels that would provide an after tax distribution equivalent to that currently enjoyed by our Canadian taxable Unitholders.

This statement implies that their distribution will be reduced to approximately 32 to 33 cents per unit (6.89%). This is a few pennies lower than what I was expecting (mainly 0.46/(1+26.5%) = 0.36 in 2011; 0.46/(1+25.0%) = 0.37 in 2012) but we will see. The company has been doing a good job keeping distributions lower then their free cash flow and have applied the retained earnings into a reduction in leverage – something I find to be a wise decision that will facilitate a much easier refinancing of the debentures.

Merits of the GIC-only investment strategy

I was reading an article on the Globe and Mail about David Trahair, who advocates a GIC-only investment strategy.

Despite the relatively negative income tax implications (the income from the GICs are fully taxable unless if sheltered in an RSP or TFSA), it is not a bad strategy because it can be implemented with a few clicks of the mouse and should provide protection of principal in most situations. It is something even the most unsophisticated investor can perform and you can shop around for the best GIC rates by using a site like GICBroker.com as a guideline for where to get the highest rates.

The only relevant risk worth mentioning is that you are exposing yourself to is inflationary risk (loss of purchasing power of principal), but given the relatively low duration of investment (an average of roughly 3, assuming you are using a GIC ladder) should properly capture heightened interest rate expectations if and when CPI inflation does occur. Right now the best 5-year GIC is a good 100 basis points higher than the equivalent Government of Canada 5-year benchmark bond rate (2.47% vs. 3.5%).

The other comment is that James Hymas makes a very good argument for preferred shares in a portfolio that will diversify the risks associated with having a GIC-only portfolio, and makes for a very good read. Implementing such a change in a portfolio does involve quite a bit of financial sophistication for the do-it-at-home investor, however.

First Uranium will be an interestnig story

Ever since the environmental permit for their tailings mine got revoked by the South African government, First Uranium equity has traded lower. Their debentures have also traded from roughly 75 cents to 71 cents.

Today, however, they will likely trade lower because of First Uranium’s corporate update. In it contains the following words:

The announcement of the withdrawal of the EA has not only delayed construction of the TSF, it has also disrupted certain well-advanced corporate financing opportunities, which, along with the slower than expected production buildup at the Ezulwini Mine, would, if alternative financing is not obtained, severely compromise the Company’s financial position. The Company is now reviewing strategic alternatives, and is engaged in discussions with respect to alternative financing opportunities.

My guess is that the common stock will trade down about 10% on Tuesday and the debentures will trade down another 3 cents. The company will likely have to sell more equity in future gold sales (as they have done previously), or equity in their company in a heavily dilutive offering. Management does not own too much common stock and is likely to dilute through equity to reduce the influence of Simmer and Jack.

The latest financial update from First Uranium was at September 30, 2009. The debentures are CAD$150M and they would be first in line (after a $22M facility) in the event of a default.

The valuation of First Uranium, as its operational woes continue, have to increasingly be looked with respect to what the asset value of operations would capture in the event of a bankruptcy proceeding. As long as the price of gold does not crash, there is value in the operations and debenture holders will likely be able to still make a fair recovery.

Most of the value of the debentures, assuming they are paid, will be in the form of capital gains so keeping these outside the RRSP is likely the best option – at 65 cents on the dollar, your split will be 1 part income to 3 parts capital gains, assuming they mature. Any resulting income will be taxed at around 62% of the income produced from the investment.

Debt and confidence

John Mauldin summarizes a part of the book This Time is Different by repeating that a sudden drop in confidence is what drives economic crises. A lack of confidence is more pronounced in debt crises because if the market collapses for debt renewals, you will have to default, which triggers a worse cascade of events.

It is also difficult to predict when the confidence is lost, but when it does occur, it is usually sudden, as witnessed in the 2008 financial crisis.

Whether another financial-type crash will occur in North American markets is up for debate, but whenever such a crash happens, one is best to brace for impact in terms of one’s portfolio and personal financial situation – high debt leverage is the big killer.

Frontera Copper Note Exchange

Frontera Copper was acquired some time ago by a Mexican company and at that time its common shares were delisted. The company still had some notes outstanding, however. They were defaulted on by the company mainly due to financial issues that resulted from the acquired mine assets not being worth what the acquiring company believed they were worth.

There are two series of notes, both senior unsecured notes, with a coupon of 10% and a maturity date of June 15, 2010 and March 15, 2011. They are trading around 67 cents on the dollar. The company has proposed an exchange offer whereby people can tender their notes and receive 90 cents of face value (if tendered early) of new notes earning 10% interest, maturing December 2012. The terms also include that if copper goes below US$2.90/pound, the notes will give 6% interest. Also, the notes will be repaid in 25% installments, starting 18 months after they are issued, and can be extended by another 6 months if copper is below US$2.35/pound. Finally, if the notes are exchanged, unpaid interest on the previous notes will be paid.

The new notes will also be secured by a second-in-line interest on the mine assets after the bank loan, but this security is likely not worth too much.

The only kicker is that the new notes will not be exchange traded.

I am not seriously interested in these notes or the exchange offer, but thought it was an interesting offer. The fact that the market price for these notes plummeted when they announced this offer suggests that the bond market will not be expecting they will be paid in full, despite the effective 13-14% current yield they will receive after the exchange offer. Also, liquidity risk is a serious consideration with respect to the untradable nature of the notes. Finally, the international nature of the notes in question (essentially being secured by a Mexican operation and a Mexican corporation) leaves jurisdictional risk issues in case if they decide to default – who do you end up suing? A worthless BC shell corporation when the assets are held in a Mexican corporation?

It are risk factors like these that made me pass up the risk on this offer, but it might be for some other people to analyze and make a killing if the deal actually works for noteholders.