Canadian Finance, Economics and Fiscal Analysis
If you ever wanted to liquidate $2 million dollars of the CASH.to ETF in the last four seconds of trading, look what happens!
I could not imagine went on in the mind of somebody punching this order into the computer. Reading the tape, those sitting at around $49.75 on the limit would have received a reasonable fill and this is the financial equivalent of picking up the freest half a basis point on the planet.
Those of you that tuned into the last episode of Late Night Finance will know that I took tiny positions in a couple office REITs, which I took the liberty to dump out subsequent to that zoom-cast (no, not a pump-and-dump, I promise).
Traditional valuation methods of real estate can use cash flow methods, capitalized costs of land/building, and gut instinct on where future market demand lies, but there is one universal truth and that is when vacancy rates are high, it is not a good sign of how much cash flow you can dredge out of a property.
We are starting to see downward pressure on various office properties (WSJ article), at least in San Francisco.
While the specific example in this article may be an extreme case (a mark-down of 80% or so from pre-Covid pricing), because mortgage and other secured financing is collateralized by real estate asset values, it stands to reason that many other office REITs are going to face issues with trust covenants of specific debt-to-asset ratios going forward.
Since real estate loans are a slow-moving process, it will take a sustained credit-tight environment to trigger more and more financial stress on these entities, but just like how Silicon Valley Bank and Signature Bank New York were the first canaries in the coal mine, it will be inevitable that we will see the first office REITs start to fall – the trigger will be forced liquidations of office properties.
In highly anticipated news, First Republic (NYSE: FRC) went bye-bye over the weekend.
As long as the yield curve remains inverted and quantitative easing continues, financial institutions are going to receive continued pressure and the “too big to fail” institutions will be the ones to vacuum up the money.
Think of it this way – behind each bank asset (a customer loan) is a bank liability (a customer deposit). If the asset to liability situation goes out of regulatory proportions (e.g. you took your customer loans and invested in them in high-duration government debt and suddenly your customer wants their deposits back and you can’t pay it), you get FDIC’ed. However, when the FDIC process occurs, it is not as if all of that capital goes away – it has to go somewhere. It doesn’t end up as paper banknotes inside the safe or underneath the couch, but rather it goes to another financial institution. The assets and liabilities go somewhere else within the financial net – they do not vanish!
In this case, it appears destined that the assets in this digital financial world (where assets get transferred with mouse clicks) will bubble up to the systemically important banks.
I’ve been trying to pick away at the entrails of the lesser banks within the USA, but I don’t have a clue how to project who will survive and who will not. So I’ve given up.
I will leave this post with one amusing note. Financial releases go through plenty of review cycles within management, but if they can’t spell the word “average” correctly, it is trouble:
There is a paradoxical rule in investing that when you anticipate the underlying price of whatever a company sells to rise, you want to be invested in a higher cost producer. The reason for this is embedded leverage. In a flat to declining price environment, you want to be invested in the low cost producer.
An example will suffice.
Say the market rate for widgets is $100. Company A (high cost producer) can make widgets for $90 a piece, leaving $10 of profit per widget. At a 10x multiple, the company would be worth $100 a widget. If the price of widgets goes up to $200, the company would be worth $1,100 a widget, 11x your money at the same multiple.
Company B (low cost producer) makes widgets for $50 a piece, leaving $50 of profit per widget. At the same multiple, it would be worth $500. If the price of widgets goes up to $200, Company B would be worth $1,500 or a mere 3x. Not bad, but nowhere close to the high cost producer.
The reverse is true – especially if the price of widgets goes below the costs of some producers. If the price of widgets goes to $70, Company A will suffer (they will have to dig into their balance sheet), while Company B will still make a living.
Markets can anticipate these leverage effects and compensate valuations accordingly – in particular price to earnings multiples decrease as prices increase. But over market cycles, costs matter.
I’m looking at earnings of coal companies, and the contrast between ARCH and BTU is quite striking.
In Q1-2023, ARCH produces its metallurgical coal at a cash cost of US$82.66 per short ton, while BTU is $151.13. In Q4-2022, HCC was $123.40, while AMR was $112.97. Teck reported US$103 per metric ton, which is about US$94 per short ton. (In the case of Teck, there is a bit of an accounting fudge factor as some of this cost is the amortization of “capitalized stripping”, which creates unevenness in cash flows, a technical matter well beyond the point of this discussion).
As met coal prices come back down to earth (they were as high as US$450 per short ton last year and are roughly US$260 or so presently), low cost producers should start to feel the pinch on their cash flows.
It leaves the question why one would want to invest in a company producing a commodity in a lowering cost environment, and that is where some market skill comes into place – there is an anticipation of cyclicality in these companies. You can also play expectations against each company by engaging in pair trading – long one, short another (and pray that your short doesn’t get bought out).
However, there is one raw number that really counts – cash dividends. If you’re going to get paid a reasonable return on equity, it still might be good enough.
In this respect, ARCH’s 50/50 plan (which is giving 50% of free cash flow directly off as special dividends and the remaining 50% for debt/capital/remediation/buybacks) has a certain elegance to it. As more shares get repurchased, the amount of the dividend that gets distributed will rise over time. It is like a very strange version of dollar cost averaging except the company is deciding to do it for you.
In 2022, ARCH gave out about $25/share in dividends. I do not anticipate this level of distribution will continue. For one, they will start paying significant cash income taxes which will reduce the dividend stream. However, there is a reasonable chance that the cash payouts will continue being in the double digit percentages, coupled with share appreciation through buybacks. Another paradox about having high amounts of cash flows is that you want to see the stock price lower, not higher – the reason is because reinvestment (in the stock) can compound at higher rates when done at lower prices.
It would not shock me in the least to see some more consolidation in the sector. We’re already seeing Teck trying to avoid one.
Also, for reference, read my December 2019 post on Arch. Even after Covid-19, this write-up is aging pretty well.
A hat-tip to Frank L. for pointing out that Crown Capital Partners (TSX: CRWN), a little-known microcap financing company, on April 11, 2023 issued a proposal to refinance their $20 million face value of convertible debentures trading as (TSX: CRWN.DB).
The salient features they are offering are:
* Extending the maturity date of the Debentures from June 30, 2023 to December 31, 2024;
* Amending the interest rate on the Debentures from 6% to 10% effective July 1, 2023;
* Removing the conversion right of the Debentureholders; and
* Removing the right of the Corporation to repay the principal amount of the Debentures in common shares of the Corporation (“Common Shares”) on the new maturity date or any redemption date.
This company wasn’t on my radar but I gave it a closer look and glossed through their annual financial statement.
First, I noticed that there is quite a bit of consolidation going on in their entity (which means it takes a lot of time to dig through – time I, quite frankly, did not want to spend). A material amount of their assets are in the non-current category consisting of their investments (Crown Partners Fund, leased distributed power equipment, and other property and equipment). Needless to say it isn’t exactly of the variety that you can put it up on Ebay and dump for some quick cash.
The other thing that struck out at me is that they had $7.2 million cash on their balance sheet, and $11.9 million in mortgages payable (November 2023), $18 million in credit facilities (long-dated), and of course the $20 million in convertible debentures.
The credit facility’s fine print, is the following:
Effective February 7, 2023, the Corporation entered into a new senior secured corporate credit facility with Canadian Western Bank of up to $43,500 to be used to fund a full repayment and cancellation of lender commitments in respect of the Crown Credit Facility, support working capital and growth capital requirements of the Corporation and its operating businesses, and to fund the Corporation’s remaining capital commitment in respect of Crown Power Fund. The new senior secured corporate credit facility replaced the Crown Credit Facility and includes an amortizing term loan of up to $30,000 with a maturity date of February 7, 2028, an operating loan of up to $10,000 with availability subject to margin condition restrictions, and a letter of credit facility of up to $3,500. The term loan is comprised of an initial advance of $25,000 plus $5,000 to be advanced upon request by the Corporation prior to June 30, 2023. The term loan and the operating loan provide financing at variable interest rates based on Prime Rate plus 165 bps to 265 bps and 200 bps to 300 bps, respectively, and feature a customary set of covenants.
(You want to know why Canadian Western Bank (TSX: CWB) is trading like it will go First Republic Bank (NYSE: FRC) any moment?)
Pay attention to the rate paid. Prime is 670bps at the moment, so the term loan is 8.35% to 9.35% and the operating loan is 8.7% to 9.7%, floating.
In addition, you have the mortgage payable which has the following fine print:
Effective May 27, 2022, the Corporation entered into an agreement for a mortgage payable of $11,900 that is secured by the value of property under development, has a maturity date of November 30, 2023, and bears interest based on Prime Rate plus 570 bps (with a floor of 8.40%) per annum.
Prime plus 570bps is a 12.4% mortgage! Holy moly!
So why on planet earth would the convertible debenture holders agree to an unsecured 10% coupon when clearly the cost of capital for the other secured lending the corporation is taking is at much higher rates and you lose the (nearer) maturity date advantage? They generously offer a 1% consent fee for a yes vote!
The last thing I’ll point out is that they spent $24.8 million on share repurchases over the past two calendar years. Money that could have been better spent on… perhaps redeeming this debt?
The debentures are really illiquid, the stock is unshortable, and I have no positions in this company, nor do I intend on taking any.