Miscellaneous Market Notes

Quite a few things going on.

1) With the rejection of the Canfor offer, the stock went from $15 to $12, but recovered to $13 as I’m writing this. Many investors are probably engaging in the Canadian version of Buffett-following, which is “if Jim Pattison thinks it’s worth buying at $16, surely buying at $12 or $13 isn’t that bad.”

I do agree with general market sentiment that Canfor was lowballed, but the forest industry is cyclical and most definitely we are in the low part of the cycle. When things will emerge again remains to be seen. The good news with Canadian lumber is that it is one of our few economically competitive exports and doesn’t require a pipeline to transport. In addition, environmental groups have shifted their political focus in the last couple decades from antagonizing forestry to fossil fuels, which gives them some breathing room (for now).

In British Columbia, hardly a month goes by without hearing some news about mill shutdowns and the like. The industry is really suffering right now. The renegotiation of NAFTA and expiration of the previous softwood lumber agreement (October 2015) did not help matters at all.

2) Cineplex (TSX: CGX) getting taken out at CAD$34 is a gift to CGX shareholders. A British firm, Cineworld, apparently has too much money and has spared Cineplex owners from taking future losses. As you can tell by the tone of this paragraph, I did not perceive Cineplex’s future business chances as being particularly rosy. The business did have value but not at the price they were trading at. I’ve written about it a few times in the past and will leave a chart here for historical purposes:

3) Another takeout which I thought would go through was HBC (TSX: HBC), which (at $10.30) was withdrawn by the proponents (Baker Group and others, 57%), and a subsequent $11 offer by another significant minority shareholder group (Catalyst, 17.5%) was rejected by the shareholders offering $10.30. This is a gigantic corporate governance mess, but what was interesting was the posting of all the real estate appraisals on their investor relations site. Get some commercial quality information for free!

4) I’ve actually been active taking small stakes in various companies in late November and December. The range of companies is widely varying. For the first time in quite some time, I’ve deployed some capital south of the border.

Two shareholder votes to watch out for this week – Canfor and Pengrowth

Two shareholder votes happening this week which will be of interest:

Vote #1: Canfor

Canfor (TSX: CFP) will vote on Wednesday, December 18, whether they want their minority shareholders (49%) to be taken out by the majority (51%), which is currently owned by entities controlled by Jim Pattison. The proposed takeout price is CAD$16/share, which was higher than its trading range for most of 2019, but lower than last year when things were looking a lot better in the forestry sector. The majority of minority shareholders is required for the vote to pass.

My guess is that this will pass. The only significant shareholder other than Pattison’s entity is through director Barbara Hislop, who controls about 2.5 million shares (out of 125.2 million shares outstanding). The rest of the shareholder base is likely to be institutional in nature and I do not think they will put up much of an opposition. At Friday’s closing price of $15.45, this seems like an easy 3.5% gain in two days of trading for those that are brave to place a bet.

Most other forest companies have gotten killed – WFT, IFP, WEF and especially CFF – picking look slim right now.

I think Pattison’s sense of market timing is excellent with this one – buy low and collect the cash when the times are better again, and they will be. The fact that this isn’t a no-brainer suggests that he’s getting a good price on the acquisition – indeed, if 99% vote to agree to it, he probably paid too much. But if 60% of the minority agree to the deal? That’s a perfect price.

(Update, December 16, 2019: The deal was rejected with 45% of the minority in favour of the deal, with 50% required. Guessing that Pattison wished that he added another 50 cents on this one to seal the deal!)

Vote #2: Pengrowth Energy

Pengrowth Energy (TSX: PGF) will also be voting December 18. The proposed acquisition price is 5 cents a share, mainly because the company has debt maturities outstanding that will likely be defaulted on if the vote goes negative. The only real question mark at this juncture is why Seymour Schulich, who owns 28% of the common shares, all of which have been purchased at significantly higher prices, is going along with this. He purchased a couple million shares as late as July of this year (for approximately 50 cents a piece) and owns 159.4 million shares out of the 560 million outstanding. Is this going to be the mother of all capital losses? Or did he cut a deal with Cona Resources (the acquirer) that will take place after the transaction concludes?

For somebody with patience, I think Cona is getting an excellent deal. With the debt eliminated, Pengrowth is very highly leveraged to ambient oil prices and if there is any revival in the market, the pain that these companies have gone through in the past half decade will be nowhere close to the rewards that will be gained in the future.

One nail before the coffin shuts on Fortress Global Enterprises

The three-year chart of this company is self-explanatory:

If you ever wanted to own a huge stake in a soon-to-be delisted publicly traded company, now is your opportunity – put in a bid of a penny and see how many of the 14,971,799 shares outstanding you can capture before you have to take a zero!

Earlier this week, Fortress (TSX: FGE) announced:

VANCOUVER, Dec. 10, 2019 /CNW/ – Fortress Global Enterprises Inc. (“Fortress” or the “Company”) (TSX: FGE) (OTCQX: FTPLF) announces that it has failed to receive any indications of interest pursuant to its previously announced strategic and financing initiative (the “Strategic Initiative”) by the required deadline under the financing agreement (the “Financing Agreement”) entered into among the Company’s wholly owned subsidiaries, Fortress Specialty Cellulose Inc. and Fortress Bioenergy Ltd., and their secured lenders or their affiliates (together, the “Lenders”). Failure to meet a material deadline under the Strategic Initiative when required constitutes an event of default pursuant to the terms of the Financing Agreement.

With $208 million in debt outstanding (and this debt being accelerated due to covenant breaches), and the operations being cash negative due to the pulp industry, it does not look good at all.

$62 million of the debt consists of convertible debentures (TSX: FGE.DB.A), which are trading at 0.1/$1,000. Amateur investors don’t apparently realize that this amount trades with accrued interest – i.e. with the 9.75% coupon, a purchaser would pay virtually nothing for the convertible debt, but they have to send to the seller nearly 487bps in interest!

In CCAA, the recovery on the debentures are most likely to be zero.

That concludes today’s financial amusement.

(Update, December 15, 2019): Well, that didn’t last long. They went into CCAA on the evening of the 13th.

I’ve posted a chart of the debentures for historical reasons.

Mogo Debentures – observations

Scanning the TSX fixed-income trading list, one name stuck out at me: MOGO. They amalgamated with Difference Capital to shore up their balance sheet.

They have $12.7 million in debentures outstanding (TSX: MOGO.DB) which are trading at 93 cents on the dollar. Considering the short term maturity date (June 6, 2020) it makes for an effective 26% yield to maturity when adding on the 10% coupon they give out. What gives?

Mogo’s balance sheet has a lot of high-interest debt (especially in relation to its cash-negative operations), but they are slightly further back in maturity dates than the debenture’s June 6, 2020 maturity. In particular, they have (secured debt) $46.6 million outstanding due July 2, 2020 (with an interest rate of LIBOR+12.5%!) and $31.9 million due August 31, 2020 (LIBOR+8.00%).

These ridiculously high premiums over LIBOR should give an investor an idea as to what risk the banks are (thinking they are) taking in this firm, so at the very minimum, an investor should demand a higher rate of return on unsecured debt.

My guess is that management will be in a position to extend these credit facilities (barely), but one condition (among many) will be that the debentures are converted into equity.

Many convertible debentures have a clause that allows a company to convert them into equity based off of 95% of the volume-weighted average price for the past 20 days of trading on the TSX (usually 30 to 60 days of notice is required, so an investor can have a fairly good grasp as to what the conversion price will be), but I notice that MOGO’s is at the VWAP and not 95% of the VWAP.

It is likely an investor in the convertible debentures is going to receive shares. Today, Mogo’s market cap is 106 million, so a conversion of about 12 million par value is not going to take the stock down too much upon management giving notification of conversion.

Enterprising investors would think about shorting MOGO equity and purchasing the debentures, but sadly the borrow cost of over 20% makes this a prohibitively expensive trade.

I’m not interested in the debentures, but if you’re bullish on Mogo’s equity valuation (I’m not either) it is worth a gander.

Reversing course on a trade – Tailored Brands

A good part of investing is trying to constantly trying to figure out whether the information that got you into a trade is still applicable or whether it is flat-out incorrect. Unfortunately, the information that you glean from investing without insider information is diffuse and sometimes the decisions made are marginal ones – hence, it is never wise to bet too much of your portfolio on any investment thesis. More certainty of information over your perception of the information that others are pricing into the security allows for a more concentrated bet.

In the instance of Tailored Brands (NYSE: TLRD), it was a combination of diffuse information, hence a relatively modest position. There was a panic in September, coupled with management’s capital allocation decision to cut the dividend to zero, coupled with the actual numbers looking relatively cheap from a valuation perspective (they are a legitimate retail operation, albeit selling product that is facing an overall downtrend for various reasons). September quarterly guidance was very tepid which took the stock down:

* Men’s Wearhouse to be down 3% to 5%
* Jos. A. Bank to be down 2% to 4%
* K&G to be down 2% to 4%
* Moores to be down 4% to 6%.

I got in and out and flipped the stock like a pancake for mild profits. If you’re a large player, it takes a lot of time to scale in and out of stock positions and “pancake flipping” isn’t really an option – you’ll move the price of the stock too much on both ways.

What changed my thesis? One was that Gildan (TSX: GIL) is a precursor fashion company, and they pre-announced in October that things aren’t going too well. Obviously selling things such as t-shirts and underwear is not the equivalent of selling suits and fancy clothing (which involves more marketing and physical presence than raw material), but it was the continuation of the downtrend which is not a good sign. Does this guidance carry forward to other apparel retailers? Does TLRD’s already down-beat guidance already incorporate this, or will things be better than that or worse?

This is ultimately what makes it very difficult to judge as a market participant – what the market is currently betting on. Every piece of information is condensed down into one, and that is price – the assumptions driving the price among the market participants can only be inferred, and sometimes the causes for price changes are for completely hidden reasons (e.g. some hedge fund has to liquidate its entire holdings in a short time period at any price, and does so indiscriminately – these sorts of situations are great to get on the other side of the trades with).

The other reason why I closed out the trade was that I figured is that the psychological exhaustion associated with the suspension of the dividend, coupled with any anticipated benefits of a share buyback had played itself out. What I mean by this is that when a relatively well-known company suspends its dividend, there are many funds out there that invest in the company’s stock strictly on the basis that it has a dividend (any dividend or income-oriented ETF and so forth). These funds are forced to sell the stock within a predefined timeframe because they no longer fit the portfolio policy. Hence, when you see dividend suspensions, investors do not like it because it signals a negative psychology (Can’t pay a dividend anymore? Must mean you can’t make money to pay it, so I should sell!), but also for completely mechanical reasons (funds and ETFs selling due to policy).

Example: Vanguard at August 9, 2019 reported owning 6.8 million shares. Vanguard at October 10, 2019 reported owning 3.4 million shares. Vanguard, of course being the low-cost ETF provider of all sorts of funds running hundreds of billions of dollars of investor capital – pretty clear their income/dividend funds were getting rid of TLRD stock!

It could be the case that suspending the dividend to focus on stock buybacks is rationally the correct decision. Indeed, managements with value-creating characteristics would choose to engage in that, knowing that a dividend suspension would crater the stock price – it would just mean you can buy back more equity at depressed prices. The smartest managements time their annual option grants to coincide with this period, to get the lowest strike price!

Finally, TLRD’s cost of capital has increased considerably over the past month. This has been really noticeable over the past couple weeks where yields have risen on their July 2022 unsecured debt to about 10%, which is the point where the bond markets are getting quite nervous.

I’m guessing unsecured bondholders are not thrilled that some of the capital that is destined to pay them back is going into the hands of the stockholders. This is assuming management is repurchasing shares in lieu of the suspended dividend, but we will not get confirmation of that until the next quarterly report.

If there is a meltdown in TLRD, it will be very fast and spontaneous – similar to what happened to Toys R’ Us – bondholders will not have the opportunity to get out without taking a significant haircut. One big difference, however, is that TLRD still makes some money, so they have that going for them. That amount of money, as top line sales decrease, will be more and more difficult to realize without very diligent cost controls. It is one thing to manage a franchise that is on its way up, and another thing entirely to manage it on the decline – a whole different skillset is required to manage declines gracefully.

TLRD announces their next quarter on December 11, so we will see what happens. Such skittish trading is not the best way of making long-term gains but the cliche of cutting your losers quickly and let your winners run is also overriden by another cliche – when your original investment thesis is broken, get out. There’s always a market somewhere else.