Looking at Sodastream

Sodastream (Nasdaq: SODA) is an Israeli company that markets those “make it at home” carbonizers where you can make frizzy water, juices, and so forth, at home. Pepsi announced it would be buying it out for $3.2 billion.

What’s interesting is the financial history of the company:

From 2013 to 2015, the company actually had declining revenues (down over a quarter) for a couple years and their profit levels went down as well. However, in 2016 they got back on track and managed to find a way to sell more and do it more profitably.

When looking at the stock chart:

Clearly in the middle of 2015 to the beginning of 2016, when things were at their financial worst, the market had valued SODA like it was some fad cupcake stock (wiki), but this would have been the perfect time to buy. A well-timed $12 investment would have turned into $142 presently.

The financial metrics of SODA at the end of 2015 (ended 2015 at $16 but crashed to $12 in January and February 2016):
Price/Sales – 0.83
Price/Earnings – 29

Today, Pepsi is paying (using 2017 financials, please realize I’m taking a shortcut and not using Q1 or Q2-2018 figures and taking the past 12 months) a Price/Sales of 5.9 and a Price/Earnings of 43.

Incredible. Let that sink in for a minute since people buying into Sodastream in late 2015 or early 2016 have made a fortune.

I’ll note that the balance sheet of SodaStream is not that special – it has a bit of cash in the bank, and no significant debt. They are not a book value play at all. The balance sheet (other than internalized Goodwill) is not a factor at all in this investment.

Finally, I will leave this following comment about investment psychology: Imagine you were convinced that Sodastream was going to turn around and start making significant amounts of money again at the end of 2015. You bought shares at $18 and took a heavy position in December 2015. Just a month later, your position was down to $12/share and it is a third (33%) under water. At that time, you must be feeling pretty stupid about your investment, not knowing that it would skyrocket over the next two years. The psychology of investing is a very odd one – at that point of maximum pessimism (at $12) people would probably question their own investment decision, whether the market sees something they didn’t. There were probably people that bought in at $18 and sold out at $12 because they couldn’t take a 33% loss on the way up to a subsequent 1,100% gain.

Dundee – Preferred Shares

Right now the largest yielding preferred shares trading on the TSX are of Dundee Corporation (TSX: DC.A), consisting of two series: (TSX: DC.PR.B and DC.PR.D). They are trading under 40% of par and current yields of roughly 14.5%. A long time ago, I had invested in their redeemable preferred shares, but I have not touched them since their maturity extension.

James Hymas had fairly cogent remarks that I would suggest that you read.

I will add that Dundee’s last quarterly report is an absolute disaster. Most of their consolidated operating subsidiaries are losing money. The two posting profits are Dundee Energy and United Hydrocarbon. Dundee Energy is now a shell stripped of its operating assets, and United Hydrocarbon is posting profits on the basis of probabilistic revenues with “contingent consideration” on the outcome of events in the Republic of Chad. (Where is Chad? Google Map link here – I normally consider myself good at geography, but my mind had to struggle with this one…)

Their flagship real estate project, Parq project in Vancouver (via a limited partnership in Paragon Holdings) is deeply in the red. The operating loss in the first half of 2018 was $13.9 million (and a total accounting loss of $80.8 million as they have amortization and also had to write down their Paragon Holdings value to nil). The financing load is killer – $52 million in interest for the first half. Remember my post about revenues and domestic currencies and loaning money in USD? $26.6 million in foreign exchange losses due to Canadian dollar depreciation. They’ve had to inject emergency capital into the entity and Dundee had to float them a $15.5 million loan at an interest rate of …. 20%!

The Corporation provided an additional $15.5 million in the form of a 20% convertible promissory note during the second quarter of 2018. The convertible promissory note matures on October 1, 2018.

Given that Dundee is behind $546 million dollars of first and second-lien debt in Paragron’s capital structure, Dundee is faced with a horrible choice – give it up, or dump more money into the fireplace.

How the heck can you lose money on Vancouver real estate? Dundee’s apparently figured out the way to do it.

The only silver lining is that their balance sheet still has liquid assets they can transform into cash. Publicly traded investments include $164 million, but $114 million of it is Dundee Precious Metals (TSX: DPM) (down to $107 million today). This would not be easy to liquidate quickly. Their $18 million investment in eCobalt (TSX: ECS) is down nearly half of what it was on the June 30, 2018 valuation date!

The rest of these investments are private and would be even more difficult to liquidate.

The holding company also has no debt – consolidated, there are about $110 million in loans outstanding, but these are in subsidiaries that do not have recourse to Dundee. Half of this debt will go with the disposition of the Energy subsidiary.

Holding company cash is $30.5 million. Adding this to the aforementioned $110 million in publicly traded securities should give Dundee some time to work with. They also have an open credit facility of $80 million. The operations are burning $10 million a quarter, but this should decline in the future as they sell off or get rid of these businesses.

The real fly in the ointment is the upcoming June 2019 redemption of DC.PR.E, which is puttable by holders after that date. This is a $82 million real liability. My guess is that management will float another crappy proposal to extend the maturity. If this fails (indeed, the terms would have to be significantly more generous than the previous offering in light of the fact that the other preferred shares are trading at a 14%+ yield), given the liquidity situation of Dundee, this will probably be redeemed in shares at the minimum price of $2.

This leaves the other preferred shares. Par value of a total of $130 million and giving out a dividend of $7.3 million a year (until the September 2019 rate reset, which will likely lead to higher distributions). Will Dundee be able to pay it? Clearly they can currently, but will the entity figure out a way to eventually make money to be able to pay these dividends in the future?

Interest rates, monetary compression

History appears to be repeating. Refresh your memory of the past 20 years of short-term interest rate changes here. Just note the late 70’s and early 80’s was a very special time in financial history and should be disregarded for historical “regression to the mean” purposes, similar to how when looking at equity charts one should mentally blank out the 2008-2009 time period as economic-crisis induced.

The last time interest rates were held at a “very low” level was back after the dot-com bubble crashed. The US Federal Reserve dropped interest rates from 6.5% to 1%, which took three years to execute (it took about a year to go from 6.5% to 2%).

Over a period of 2 years, the Federal Reserve from 2004 to 2006 raised interest rates from 1% to 5.25%. Then during the pits of the economic crisis, it took the Fed about a year to drop rates to nearly nothing, where rates remained for seven years until the end of 2015.

Now interest rates are creeping up again, although at about half the pace of the prior interest rate increase from 2004-2006. What’s interesting is that while textbook theory suggests that interest rate increases are not good for equity pricing, the opposite appears to be the case.

However, there is always a lag effect between monetary actions and the actual economic consequences of such actions. I would claim that we’ll really start to see the consequences of monetary tightening around now. Financial deals that seemed better at 0.25% financing do not seem good so good at 1.9%, and at 2.5% will seem even worse.

The real issue is the long-term treasury bond rate, which is currently 3.02%. In theory, if everything in the USA was fine and dandy, that rate should be higher.

Also, the initial signs of US monetary policy tightening is not seen in the USA itself, but rather the foreign markets. This in itself is worthy of a separate discussion, but what we are seeing today in Turkey and other external countries that are facing economic difficulties is not solely due to trade war and tariff talks, but rather that the US dollar is becoming more expensive.

All I can say (and this has become so much of a cliche) is that caution is warranted. Investment capital is best applied at reasonable valuations to entities that clearly have cash flow generation capabilities and ones that do not have complete reliance on credit markets (or conversely ones that will be able to acceptably tap the credit markets to roll-over their debt). This is doubly true if the company in question generates its profit from foreign currency, but borrows in US denominations.

The conventional wisdom says to not time the market, but I deeply suspect that over the next 12 months that we’ll see lower prices ahead.

Buying and selling retail fashion stocks

I’ve been reviewing a bunch of miscellaneous stocks today (both new and things that I’ve researched well into the past) and I will just write a bunch of short thoughts, on a topic that I don’t give much attention to, and that is fashion.

The last time I wrote about Vancouver, BC-operated Lululemon (Nasdaq: LULU) was about five years ago. I was mentioning how a $9 billion market capitalization is mind-puzzling. I’ve checked today and they’re up to $17 billion. Lest an investor think that this increase in capitalization was due to equity issuances and dilution, an investor over the past 5 years would have doubled their money. All of the price appreciation, however, was in the last year. No positions, never had any, but always curious as to the drivers that make these fashion stocks tick.

I also remember writing about Coach, and Kate Spade. Clearly I don’t frequent these two stores enough since I just checked and Coach bought out KATE for $18.50/share and changed its name to Tapestry (NYSE: TPR). I remember Coach was running into the issue of too much expansion and their main handbag products were simply not reaching that level of exclusivity that once made it a special brand. KATE investors did not do well as their brand appeal fell off faster and Coach was probably trying to consolidate that “mid-to-upper” segment.

Finally, two more Canadian companies. Roots (TSX: ROOT) has continued to dither since its initial public offering. Financially they’re still trying to figure out how to ramp up their profitability (they are modestly profitable on a yearly basis, although when it isn’t Christmas, they bleed cash).

Canada Goose (TSX: GOOS) continues to “wow” me and reminds me of Lululemon in the old days – something trading with a P/E of a bazillion. Their FAANG-styled valuation, however, is well deserved – looking at their last three fiscal years, revenues have ramped up nearly at 50% growth and gross profits have also increased percentage-wise – so more revenues, and at a higher rate of gross profit. If you can extrapolate that for the next 10 years, they’ll be able to pay of Canada’s national debt with the amount of corporate income taxes they will be paying. The question becomes a matter of whether they can pivot when suddenly seeing everybody dressed up in warm parkas with the circle patch no longer becomes fashionable.

I remember Guess? (NYSE: GES) was on my value radar screen when doing some research in this area last year. Their stock was around US$10/share at the time and I was mighty surprised to open up the quote screen and see it at US$22/share today. I have no idea whether they are fashionable again or not. You don’t see it in their financial statements, however – they’re basically a break-even operation. But Guess has always been unusual compared to some other fashion companies in that their balance sheet is debt-light and cash-heavy, which gives them a lot of time to figure out how to turn their $2+ billion in revenues into $2+ billion in profitable revenues.

Likewise, looking at Abercrombie & Fitch (NYSE: ANF), they seem to be in a similar position as Guess – the revenue drain has stopped, but profit levels are still relatively low.

In the latter two, small changes in profitability percentages will have substantial impacts on the bottom line, which gives their equity inherent leverage to a change in market environment. It’s pretty clear the market is betting on this happening to some degree.

A company that has been cited by various value Canadian investors everywhere but still receives not a lot of respect from the market is Reitmans (TSX: RET / RET.A) – people cite their strong balance sheet (it is indeed, about $150 million cash and no debt) but the entity is marginally profitable and it isn’t entirely clear how they can increase profitability. This probably is an issue facing most fashion retailers without brain-share in the consumer space. Commodity retailing, to put it mildly, it is a horrible area to be in.

Genworth MI – Capital Adequacy Guidelines from OSFI

Genworth MI (TSX: MIC) commented on the new OSFI Capital Adequacy Guidelines for Mortgage Insurers.

I’ve gone through the technical document, which is always an interesting read. If you can go through this document and be able to comfortably recite Section 3.1.1 and subsections underneath, you will know all there is to know about capital requirements for Canadian mortgage insurers (i.e. you’d know a serious component of what it takes to properly analyze Genworth MI or CMHC).

This is a consolidation document which incorporates some differences between the previous advisory guideline which was effective at the beginning of 2017.

Notably, the requirement for a mortgage insurer to update the required capital as a result in a credit change of the loaner has been removed in exchange for a flat 5% increase. They probably figured out that obtaining credit scores of your clients every year isn’t a sustainable operating practice.

This will require Genworth MI to retain more capital for the same amount of book liability, which has the effect of reducing return on equity.

There is a possibility that CMHC will increase mortgage insurance premiums as a result of this and Genworth MI would match it.

Here are some tidbits for those housing bears that think a crashing Canadian housing market will take down Genworth MI:

1. Loan-to-value is defined as follows:

For mortgages originated after December 31, 2015, the LTV input is calculated by dividing the outstanding loan balance on the reporting date by the property value on the origination date or the date of the most recent appraisal, provided that the appraisal was commissioned by an independent third party entity other than an insurer.

… and …

Note that if the value of LTV determined in this subsection is greater than 100% then an LTV input of 100% should be used in the formulas in subsections 3.1.1.2 and 3.1.1.3.

So in a crisis scenario, if people are suddenly underwater on their mortgages, it doesn’t matter to what degree they are underwater – the capital retention requirement only uses a maximum LTV of 100% (i.e. zero equity, not negative equity) in the calculation for how much capital they are to retain.

2. Wondering how much your credit score (at mortgage origination) affects how much capital your mortgage insurer has to retain? The “m-value” below is the factor that capital retained is affected.

Credit Score Impact on Mortgage Insurance Capital Required

Credit Scorem
< 6003.00
[600,620)2.05
[620,640)1.80
[640,660)1.60
[660,680)1.35
[680,700)1.10
[700,720)0.90
[720,740)0.65
[740,760)0.55
[760,780)0.45
≥ 7800.40

What’s interesting is that I do not see the phrase “credit score” defined anywhere in the document. Must be super-secret!