The slate is being cleaned

Slate Office REIT (TSX: SOT.un) today announced an update on its “portfolio realignment plan”, also known as “We’re trying to dump this stuff as fast as we can but can’t find anybody willing to pay a price that will pay down the mortgages” plan:

Slate Office REIT (TSX: SOT.UN) (the “REIT”), an owner and operator of high-quality workplace real estate, announced today that it continues to make progress on its previously announced portfolio realignment plan, and in connection with the foregoing, continues to engage with its senior lenders to determine a mutually acceptable path forward in respect of its obligations to such senior lenders, including in respect of its revolving credit facility. The REIT also announced today that, notwithstanding those ongoing discussions, its senior lenders have provided notices of default, which currently restrict the REIT from making further payments of accrued interest in respect of its outstanding debentures (collectively, the “Debentures”), for so long as such defaults have not been cured or waived. The REIT has determined that based on the information currently available to it, there can be no assurance if or when a cure or waiver in respect of such defaults will be achieved, and as such, the REIT does not expect to make the cash interest payments due on June 30, 2024 in respect of its 7.50% convertible unsecured subordinated debentures and 5.50% convertible unsecured subordinated debentures, nor does it expect to make the cash interest payment due on August 31, 2024 in respect of its outstanding 9% convertible unsecured subordinated debentures. Pursuant to the trust indentures governing such Debentures, failure to pay interest on the Debentures for 15 days following such interest being due will give rise to an Event of Default under the terms of the Debentures.

Needless to say, it isn’t looking good for them. This could be inferred from previous public filings, in addition to them having to beg to shareholders to go above their prescribed asset to debt ratio.

My attempts at being a corporate raider (November 2022) was incredibly brief before I came to the conclusion that there’s no way to win.

My question is not necessarily for Slate (we will see how George Armoyan can try to salvage this situation) but rather whether there will be any ripple effects in the office REIT sector if Slate does decide to go into CCAA. In the sector include AP.un, D.un, SOT.un, TNT.un, and diversified REITs which contain significant office components including BPY/BPO (preferred shares), HR.un, AX.un, and to a lesser extent MRC/MRT.un.

One implication of the capital gains changes

Maximum price changes occur when there is demand or supply added to the market in a very short period of time.

The upcoming finalization of the June 25 “Delivering Tax Fairness for Canadians” capital gains tax inclusion rules has created an interesting ripple in the market.

Well-pocketed individuals or anybody managing a portfolio within a corporation that anticipated an upcoming liquidation of unrealized gains over the next three to five years are compelled to realize such gains in the next 5 trading days. The math is pretty straight-forward for somebody in the top Ontario marginal tax bracket – you sell your shares today and $10,000 of capital gains results in a $2,676 tax bill, or you sell your same shares at the end of this month and it will result in a $3,569 tax bill. The value of the tax deferral of the capital gain only reaches a break-even point in about 5 to 6 years assuming a 9% rate of return – quite a liquidity penalty if you decide to hold! (See: RBC report, page 8 and 9 for some reasonable analysis on the matter).

The people that have the capital to be concerned with these rules (over $250,000 in individual capital gains, or any capital gains in a trust or corporation) are more likely to have the economic substance to push the market in a short period of time with a significant amount of assets.

Hence I deeply suspect that there has been over the past week or so and will be, until June 21 (note – the change occurs on or after June 25 and now that stock trades settle T+1day, the last trade you can do is Friday June 21 to qualify for the 50% inclusion rate), a very unique form of “tax gain selling” on stocks that have reasonable potential for gains to be realized.

All things being equal, next week may prove to be a better than not opportunity to put capital to work.

A little bit of QT – and general economic thoughts

The whole financial sector of the country knows that the Bank of Canada dropped interest rates by a quarter point a few days ago (from 5.00 to 4.75%). Those holding floating rate debt will see a little bit of alleviation of expenses, and those holding CASH.TO and the like are seeing their risk-free rate drop – nudging the capital further right along the risk spectrum.

However, the overall picture of the inverted yield curve has not changed –

It is still deeply inverted, with a 125bps spread between short and long term yields.

The transmission rate of dropping interest rates (or raising them) and the impact on the real economy is a very slow process – the literature cites around 12-18 months before the full impact of rate hikes and drops come into play. Entities look at their cost of capital and decide to invest or not in projects (e.g. residential strata condominiums or chemical factories) that have a five year development cycles and when the decision is made, the economic impact occurs well into the future. It is not like you can order one of these on Amazon and get it shipped in a day!

You can infer this by looking at employment statistics. Why is construction labour down about 34,700 jobs year-to-year? Major capital projects are running off the ledger (e.g. TMX is finished, Coastal Gaslink is nearly done, etc.) and the decisions to do residential construction occurring in cities were made in 2021 when rates were at rock-bottom and these projects are just completing now. The only sort of capital projects are are hitting the “buy” button are government works – except these are all running into massive cost overruns (e.g. using some BC examples, the Site C dam, the Metro Vancouver sewer plant, any hospital project, the Broadway Skytrain project, etc, etc.). Only government projects are allowed to have any amount of money thrown at them for completion – and this of course attracts contractors like a moth next to the flame. When your competition is able to spend infinite amounts of money, what makes you as a private developer, able to compete for those services? No chance at all – hence cost inflation. With your cost of capital is still relatively high, there’s no avenue for profit.

Finally, I will observe that the progression of quantitative tightening, albeit very slow, is still progressing – the following chart is the “Members of Payments Canada” line item on the liabilities ledger of the Bank of Canada:

The last slab of QT took the “Members of Payments Canada” line item (which is a measure of reserves the financial institutions have with the Bank of Canada) below $100 billion for the first time since the Covid-19 pandemic. As the current $248 billion stack of government bonds, mortgage bonds and provincial bonds get bled off of the Bank of Canada balance sheet, there will be a corresponding drop in bank reserves held at the Bank of Canada. This is not a fast process – $15 billion is scheduled to mature in the remainder of 2024, while $32 billion is slated for maturity in all of 2025. While QT is still ongoing, it is at a glacial pace – hence, “a little bit of QT”.

My reading of the tea leaves makes me suspect that the Canadian currency is going to get pushed down further in relation to the US dollar. Canadian exporters should benefit from the upcoming shift. I also do not view this as beneficial for the domestic economy. There is not a lot of safety out there and cash continues to earn a very good risk-free rate while patiently waiting for the capital values of various entities out there to implode in some sort of panic (the last one being 4 years ago with Covid, although I am not anticipating anything with that magnitude happening again in my lifetime).

The only question that remains is whether we will see a bounceback in inflation. Given the million+ increase in demand for housing in urban areas without a corresponding increase in supply, I do suspect that the most heavily weighted component of the CPI will continue to exhibit an increase. A lower Canadian dollar will also result in costlier imports. Finally, labour inputs are also increasing – wage growth provisions in contracts are rising and here in BC, minimum wage is now $17.40/hour – and correspondingly, your “extra value meal” at a fast food joint is now at least $10, and that’s with a coupon! The wage-cost spiral is a very difficult one to break without a deep recession.

It is difficult to passively wait, but I don’t see the risk/reward for moving up the risk spectrum that good right now. Even the oil and gas sector in Canada with current commodity prices are trading at valuations that are “blah” rather than being a great value.

Any sectors out there getting your attention?

Dollarama – Valuation

Dollarama (TSX: DOL), the dollar store that is all over the place in Canada, came up on my investment radar during a screen. I last looked it many years ago, and obviously I would have done very well had I just bought it, but even back then I recall thinking the stock was over-valued. Shows you how little I know!

The following is a snapshot from their last fiscal annual result ending January 2024:

Some quick thoughts:

* Dollarama is one of the few retail segments that can effectively compete against Amazon, hence its ability to retain its margins is relatively good;
* They seem to out-compete other dollar store chains as well;
* Somehow they manage to successfully compete against the Loblaws (TSX: L) and Soebys (TSX: EMP.A) discount chains (No frills, Freshco, etc.);
* How many stores can they possibly run in Canada? 1,551 is the current number, what is the saturation point;
* Net operating margins (before taxes and interest expenses) of 25.5% – pretty damn good! Up from 23.6% in the previous year!
* Expansion out to South American in a 50.1% owned subsidiary of the company gives them more runway, but the dynamics of that market remain to be seen.
* Company is goosing up its stock price with buybacks – 7.12 million shares at $92/share

… the valuation currently is a share price of $118.32 over a $3.56/share, relatively “clean” net income, balance sheet not too levered (2x net income) with expansion expecting to increase the bottom line. DOL is trading at 33x trailing earnings, but ultimately the question here is – when do we get to the point where the entire world is flooded with these types of shops and margins come down or expansion simply stops? Dollar General (NYSE: DG) is the big fish in the USA (sales are about 10x that of Dollarama) and their operating margins are 6.3% and well down from 8.8% in the previous year! DG had quite a fall from grace, with their stock falling about 60% from their peak before they started to recover. While the market in Canada is a different (we tend to have less competition), it would not shock me if their stock had a similar change in fortune. The price being paid for shares is very high and assumes a significant amount of growth well into the future. Don’t get me started on the valuation of Costco, a retailer that I love with a stock I would never touch!