The biggest single stock re-indexing in history

This will be written about for years, if not decades to come.

The insertion of Telsa (Nasdaq: TSLA) stock into the S&P 500.

Tesla is projected to be about 1.01% of the index, although this will certainly rise as the re-indexing occurs. Already speculators have shot the stock up another 14% in after-hours trading. Tesla’s market cap is about $440 billion. S&P estimates that about $50 billion will be indexed to Tesla stock, and this is effective December 21 (when the rest of the index is also rebalanced). They released a short consultation whether institutions want to include the stock in tranches or in one gigantic bite.

Normally inclusions (and deletions) are given shorter notice, but presumably they thought they needed to give a whole month to do this one. What’s going to happen is there will be intense games played with Telsa, the likes which will never have been seen in history. Every day trader on the planet will be on this like moths to a raging flame (and indeed, some of those moths will get engulfed into the fire!). This will be one to watch. Of course, I’m too old to be doing the daytrading but I’m sure all those Robinhood players will have fun, especially with casinos still closed.

Tesla’s products are great, but valuation-wise one has to think that this really feels “toppy”, including the index as a whole. Perhaps monetary policy is such that default capital continues to get parked into the index, valuations be damned.

So the conclusion is that we have a captive buyer that is forced to pile $50 billion into a single stock. Who’s going to sell?

Canadian Energy Update

Here is a quick post on the state of Canadian energy production companies – especially as the federal government continues to destroy the industry. As of September 30, 2020 there are 12 companies listed on the TSX that are over a billion dollars in market capitalization. There are 24 between $100 million and $1 billion, and some of these names are in very bad shape indeed. Also out of these 36 companies, some are TSX listed but have the majority of their operations outside of Canada.

For this post, I will focus on those above $1 billion. Companies that are under this threshold are still invest-able but one has to pay careful attention to whether they will survive or not in the hostile regulatory environment.

If your central thesis is that fossil fuels are going to decline and die in a relatively short time-frame (e.g. 20 years) then you probably won’t want to invest in any of these. Demand destruction will impair pricing and the ability to produce supply will not accrue excess gains to any names.

However, this is not going to be the case from a simple perspective of energy physics (laws of thermodynamics if anybody is interested in studying). Renewable sources do not scale to the magnitudes necessary. It also costs massive amount of up-front investment to implement renewable energy sources. It is relatively easy to ramp up energy usage from 0% to 5%, but above this, it becomes very obvious what the deficiencies are of renewable power sources (California discovered this in the summer). Putting a long story short, the more renewable (intermittent) sources you have on a grid, the better will be for on-demand generation sources – this means either you go with natural gas (fossil fuel!) or hydroelectric (we’re mostly tapped out in North America). Batteries make sense in smaller scale operations but not in state-province level grids. Or you can rely on imports, which just like liquidity during a stock market crash, is generally very expensive or not even there when you need it the most.

With respect to transport fuels, we will classify this as passenger, freight and aviation. For passenger vehicles, we all see Teslas and the like on the road, but the infrastructure required to refine and produce the battery materials to replace a substantial portion of the automobile fleet is still a long ways away. For freight, battery-powered transport automobiles are an illusion due to the requirements of existing freight haulers (you need to be able to transport 80,000 pounds of goods at a long distance and also cannot afford to spend 12 hours at a charging station to refuel).

My opinion will change if nuclear becomes a viable option again for power generation (from a political and cost perspective, not a technical perspective).

Some pithy notes (these are the C$1B+ market cap companies):
SU, CNQ – Clearly will survive and represent playing a very long game. Personally like these much more than the big majors (e.g. XOM, CHV, COP, BP, etc.).
IMO – Majority foreign (US) held (XOM), wonder if they will make an exit
CVE – The best pure-play SAGD oil sands player (maybe to be contaminated by HSE acquisition)
TOU – Spun off another sub, largest of the Canadian NG players, FCF positive
HSE – Soon to be bought by CVE – will be interesting to see how CVE makes more efficient
OVV – Mostly American now, with big major style culture and cost structure (i.e. $$$)
ARX – Second NG/NGL play, FCF positive
PXT – Substantively all Colombia operations, that said their financial profile is quite good relative to price
PSK – Royalty Corp (royalties are not my thing – just buy the futures, although pay attention to price, if they get cheap enough, royalties are typically a better buy)
CNU – Chinese held, illiquid security
VII – Liquids-heavy gasser, FCF positive (barely), a bit debt-heavy

Chemtrade Logistics, or yield investors be very careful

If any of you hold units in Chemtrade Logistics (TSX: CHE.UN), it is quite possible in the mid-term future that the current $0.05/unit per month distribution (which was already reduced from $0.10/unit per month during the Covid crisis) will be chopped down by about a half. It’s not a guarantee that this will happen.

Chemtrade’s underlying businesses are profitable, but the amount of financial leverage they have accumulated over the years is impressively high. Back many years ago, they were trading in the upper teens despite having an effective payout ratio higher than their free cash flow generation. Although the business itself is relatively stable (it is a staple commodity producer of industrial chemicals that are foundational in nature for many industries, similar to Methanex (TSX: MX)), the leverage is probably going to be too high for the banks to get comfortable with extending credit. CHE did receive a relaxation on covenants until 2022, which will give them a couple years to get their financial leverage metrics in the right direction.

In September, they did manage to close the deal on some additional unsecured debt financing (TSX: CHE.DB.F), but it came at a higher cost – a coupon of 8.5% and conversion price of $7.35/unit, when previous issues (when the units were trading at $20/unit) were around 5% coupons and $25-30/unit conversion prices. Needless to say these debentures are well out of the money. The proceeds of the new unsecured convertible debt was used to redeem the near maturity unsecured debt that was set to mature in June 2021.

The total debt is about CAD$812 million in senior bank debt, and CAD$531 million in unsecured convertible debentures, for a total of $1.34 billion in debt capitalization. Looking at the first nine months of this year (which is not typical due to Covid, but reflects the existing reality), after interest expenses and lease payments, the company generated roughly $85 million in cash. A good chunk of this (CAD$55 million) went out the door in unitholder distributions. There’s a couple scenarios that are possible, but the easiest route is to slowly reduce debt by reducing or eliminating the distributions. The unit price will most certainly take a short-term hit, but as the company’s credit profile improves, the equity pricing (currently at a market cap of roughly CAD$450 million) looks cheap, although it is this way right now because of the high magnitude of leverage.

If there is another credit crisis (whether it is induced by the company’s actions or not) that comes along in the next year, you can be sure these units will be cratering, even further than they have already.

I remember people pumping this income trust around $15-$20, citing the high distribution yield. Right now, I don’t see a lot of pumping, and if they do cut distributions again to get the bank debt down, I’ll be closely examining the equity. I do have a small position in one of their debentures.

A pending restructuring – Peabody Energy

I alluded to, but didn’t name Peabody Energy (NYSE: BTU) as the victim in my August 10 post about a pending debt restructuring. Peabody Energy is in one of the most hated sectors, coal mining. They operate thermal and metallurgical mines in Australia, and a large thermal mine in the USA (in the Powder River Basin, Wyoming) which had its own drama with the Federal Trade Commission that I won’t get into the details. Essentially, the plan was to form a 70/30 joint venture with Arch Resources (NYSE: ARCH) to synergize a huge amount of cost savings on their (very cash profitable) thermal coal mining operation. The FTC rejected it, citing anti-trust.

My timing for the exit of Peabody’s 2022 debt was quite poor as in the prevailing 2 months after the post, the debt traded some 30% higher, but I was generally not cognizant of the state of the market (there was quite a bit of speculation embedded in the lead-up to the Powder River Basin decision which I thought was already baked into the bond price, but clearly it was not).

In their last 10-Q, Peabody ramped up the language to state:

While the Company was compliant with the restrictions and covenants under its debt agreements at September 30, 2020, noncompliance with the first lien leverage ratio covenant under the Company’s Credit Agreement (as defined in Note 12. “Long-term Debt”) is probable as of December 31, 2020, if the Company does not successfully take mitigating actions.

But what was really interesting and fascinating from a debt renegotiation perspective is the 8-K that was released which gave a fairly detailed status of the negotiations with the secured creditors, including the 2022 noteholders. Peabody wants to negotiate an extension, but the parties are far, far off (the least of which is that the noteholders want 12%, while Peabody is willing to go up to 7.125%).

Discussion Materials / November 1 resolution / November 4 resolution

I know the last thing you want to do is probably look at more slide decks, but considering that the public rarely gets to see these backroom negotiations, for those finance folks out there, you’ll get a big kick from it.

I do notice today that Interactive Brokers is no longer showing any quotes for the debt. Yesterday the closing quote was bid 36.45 and ask 46, with the last trade being $200k traded at 37. Illiquidity is one of the reasons why I dumped as quickly as I did – you never know when the rug will get pulled from underneath.

Finally – this company violates Sacha’s investing rules on ticker symbols, which is the following: If the ticker symbol has no resemblance to the company’s name, don’t invest.

Going from public to private

A few of these have hit the headlines recently in a relatively short time period:

Genworth MI (TSX: MIC) having their 43% minority interest held by the public acquired by the majority holder Brookfield; this can generally be attributed to a relatively inexpensive valuation if it passes.

Dorel (TSX: DII.A/DII.B) is going private, lead by the managing family. An investor in the COVID-19 bottom would have made an astounding 10x their investment, although at that time it should also be pointed out that their financial position was already quite leveraged (principle: the more dangerous they look, the cheaper they are).

Rocky Mountain Dealerships (TSX: RME) in a management-sponsored takeover of the company with a capital management firm. In general, I’d consider the $7/share offered in relation to the rest of the firm to be a fairly cheap acquisition.

Clearwater Seafoods (TSX: CLR), while not strictly going private, will effectively operate as such under Premium Brands (TSX: PBH) holding half the ownership while the Mi’kMaq First Nations will control the other half of the company. My assumption is the (relatively high) valuation paid has strategic value in light of the First Nations’ fishing rights – squeeze out the competition.

The last three are companies that are generally off the radar of most institutional investors. Makes you wonder if others are brewing – if your obscure company doesn’t get much love from the financial marketplace, why bother staying listed?