The endgame for Pinetree Capital

Long-time readers will know of my investment in Pinetree Capital Debentures (TSX: PNP.DB) and the various amounts of volumes written on this company in the past, probably more than anywhere else on the internet and if I may modestly say so, in higher quality.

The debentures caught my eyes when the underlying company blew their debt-to-assets covenants and while having questionable asset quality, they still had enough blood that could be squeezed from the stone which would flow through to the bondholders.

So far this has been the case – purchasing my 70 cent stones has yielded one dollar blood droplets, plus a generous annual coupon of 10%. In addition, security is granted on all assets of the company, so even if things went wrong, there was a first-in-line claim to picking what was left of the carcass.

By virtue of going from $54 million in debt to about $10 million presently, I’ve had over 80% of my initial position redeemed in cold, hard cash. There’s a bit of residual that I continue to hold. I had an order set to liquidate the position above par, but I am content on riding it until maturity (or CCAA proceedings, whatever the case may be!).

This brings me to my latest post on the company, which is subsequent to their third quarter release. The information contained in the news release is relatively useless for analysis purposes, but their financial statements on SEDAR are much more relevant and I will quote some of the material.

First of all, they were in breach of their covenants and failed to cure them and were under forbearance with a committee of debtholders. This has now passed and the company’s debt-to-assets ratio is once again under 33% (it is approximately 28% as of the end of October). As a result, the debtholders no longer have any direct control of the company’s operations.

What will follow is a simple mathematical exercise in terms of the cash requirements of the company vs. their capacity to actually pay it.

The company still has about $9.8 million in secured debt to pay off, which matures on May 31, 2016. They have an approximate $0.5 million coupon to pay off on November 30 and assuming no further maturities, another $0.5 million in May 2016.

They are sub-leasing their offices and paid somebody $1.55 million so they could get rid of their lease. $1 million is to be paid in Q4-2015, and the remainder on February 1, 2016. They pay about $0.6 million/year for their lease so they gave somebody a 2.5 year inducement on a lease contract that expires on December 2023. They vacate their office effective February 1, 2016. It is not known where they will be moving to, but one can reasonably expect that Pinetree Capital can be run out of a lawyer’s office in the near future instead of a 9,928 square foot behemoth employing less than 10 people.

The company’s burn rate otherwise is $0.8 million/quarter, so operationally they will spend about another $2 million, plus likely professional fees if they are going to do anything financially sophisticated (like liquidating their tax losses!).

So their total cash requirements to May 2016 is likely to be around the $14 to $15 million range – $10.8 million for debenture principal and interest payments, and the rest of it the usual G&A and professional expenses that all publicly traded companies must incur.

In terms of their ability to pay, they had $2.3 million cash on the balance sheet at September 30, 2015. We know they redeemed $5 million in debentures (plus $0.2 million interest) in October, so this functionally put them at a negative $2.9 million balance.

Level 1 assets included $14.2 million in equities – likely consisting of PTK, APS and AAO equities. They do have a minor amount of PRK and LAT, but disposal of these equities will prove to be difficult given the lack of liquidity.

Let’s pretend they liquidated enough Level 1 assets to pay the $2.9 million residual (or they were actually successful in liquidating some of their Level 3 assets, which would be a minor accomplishment). This leaves them with $11.3 million in Level 1 assets remaining to bridge a $14-15 million expense requirement over the next 7 months.

In other words, even if they were to get perfect liquidity on their Level 1 assets the next half year, they still are going to be short on cash.

The remaining assets are Level 3 assets, which total $24 million. However, most of these assets are private investments and hints of what these are can be dredged through previous press releases. SViral was a $5 million investment that nothing could be heard of over the past year in terms of that company’s operations (indeed if any exist at all).

Keek was a slightly more transparent case as it is publicly traded. Pinetree had invested $3 million in their secured notes and they cut a deal to sell them for an undisclosed amount of money. Did Pinetree receive 100 cents on the dollar? Or did they take a slab of equity that they can’t possibly choke through the marketplace?

Due to management not disclosing any information at all about Pinetree’s investment portfolio, one can only guess what else is in there. However, as the year-end audit comes closer, the auditors will have to determine whether management performed a proper test for asset impairment (IAS 36 for those in the accounting world reading this – I am an accountant, after all!) – i.e. is the book value as stated on Pinetree’s books actually what the fair value of those assets are? I would find it very difficult to believe that a $5 million equity investment in SViral is still worth $5 million presently.

My gut instinct says the real value of this Level 3 portfolio is worth about 25% of what management says it is, but without any real disclosure of the components, who knows?

One thing I do know, however, is that management has a huge incentive to ensuring that reported value is kept as high as possible, because they don’t want their assets to fall to the point where the debt-to-assets covenant (33%) gets breached again! My calculations show if they had to impair $6 million of their $24 million in Level 3 assets (without any offsetting gains in their remaining Level 1 asset investment portfolio), they’d once again breach the debenture covenant and have to go through the charade of curing the default.

There are a couple other options for Pinetree and both of these have been discussed before.

One is that in their indenture agreement they are allowed to redeem up to 1/3rd of the debentures in the form of Pinetree equity. The equity redemption of the remaining debentures would dilute existing shareholders by a significant fraction at current market prices (6 cents per share).

Another solution is a monetization of the capital losses the company has incurred to date in a financial transaction. Pinetree has had the dubious distinction of losing half a billion dollars in its investments over the past few years and these tax losses can theoretically be monetized by some sort of recapitalization transaction. Using a theoretical capital gains tax rate of 13% and a willing partner buying the tax credits at 40 cents on the dollar would suggest there’s about $20-25 million left to be harvested here after legal expenses. This is really the only reason why I’m holding onto the secured debt.

Either way, management is still going to be financially creative to get their debt albatross off their backs. It still does not look good in any manner for the equity holders and the debtholders will actually face some risk in terms of getting paid their due in cold, hard cash.

Disclosure: Still holding onto some of those debentures!

Genworth MI Q3-2015 report

Late last month, Genworth MI (TSX: MIC) reported their 3rd quarter results for 2015.

The headline results were quite positive – premiums written were up from $217 to $260 million in 2015 vs. 2014 for the same quarter. As a result of premiums written increasing, revenues (premiums earned) will also be booked at an increasing rate for years to come. The loss and expense ratios remained in-line (at 21% and 19%, respectively) which still give an extraordinarily low combined ratio of 40%.

Management during the conference call pre-emptively went out of its way to explain the situation in Alberta and how they are well prepared for the upcoming onslaught of the double-whammy of increased unemployment (triggering mortgage defaults) and lowering property prices (triggering an increase of loss severity when mortgage claims do occur).

Balance-sheet wise, there were a couple negative developments. One is that the company dipped into preferred shares (selling their common share portfolio at the beginning of the year and investing in preferred shares) and are currently (as of September 30, 2015) sitting on an unrealized loss position of $42 million or 18% under the cost they paid for them (which in the preferred share market is huge!). It is currently 3.4% of their investment portfolio.

The company announced it is increasing its dividend to 42 cents per share quarterly instead of 39 cents, which is consistent with previous years’ behaviour to increment the dividend rate. They did telegraph on the conference call that they will likely not be repurchasing shares with their minimum capital test ratio at 227% even though their goal is to be “modestly above 220%”. The diluted shares outstanding has dropped from 95.6 million to 92.2 million from the end of Sepetember 2014 to 2015, but as I have discussed before, I generally view these period when market value is considerably under book value to be a golden opportunity to repurchase shares instead of issue dividends.

Conflicting with this apparent excess capital is the recent announcement that they are considering a debenture offering, which would allow them to raise more cheap capital. Would this be for leveraging purposes? They were quite successful at their last capital raising attempt – $160 million of debt raised on April 1, 2014 at a coupon of 4.242% and maturity of 10 years. Current market indications suggest they would receive roughly the same yield and maturity terms if they attempted another debt financing. Raising another $250 million in debt financing and attempting a dutch auction tender at around CAD$33/share seems to be a possibility at this stage.

Finance wise, it seems like a win-win: Raise money at 4.5%, fully tax-deductible interest expense. Use to repurchase shares that yield 5.1% (which is not a tax deductible cash outlay for the company). At a corporate tax rate of 26.5%, it is a gain of 1.8% after taxes! Remains to be seen if this is what they are thinking.

This might also be because the Genworth MI subsidiary is 57% owned by subsidiaries of Genworth Financial (NYSE: GNW), which are facing financial challenges of their own – perhaps this will be an inexpensive way for Genworth Financial to raise a cheap $140 million of equity financing and still not give up any ownership in their prize profit-generating subsidiary?

Valuation-wise, Genworth MI is still trading at 15% below diluted book value which still puts it in value range, but this market valuation is clearly influenced on negative market perceptions of the Canadian real estate market – Genworth MI has still not recovered fully from the aftermath of the effects of the drop of crude oil prices. Still, if they effected a buyback at around CAD$33/share, it would still be accretive to their book value!

The company did dip below (dividend-adjusted) CAD$27/share on a couple occasions on single days in late July and August, but I was nowhere near nimble enough to capitalize on that freak trading activity. At such valuations (25% below book value) it would be difficult to not re-purchase shares that I sold in 2014 when MIC was trading at and above $40. The fundamentals of the company are that of a bond fund asset management, sprinkled with the profit generator of Canadian home mortgage insurance.

The other elephant in the room is questioning the effects of the change in the federal government – the new mandate for CMHC might be to get it more involved in mortgage insurance instead of being (relatively) non-interventionist like the previous Conservative government. This might functionally increase the competitive space for Genworth, but it remains to be seen what the Liberal Party’s intentions are with CMHC. The only line in the Liberal Platform is the following:

We will direct the Canada Mortgage and Housing Corporation and the new Canada Infrastructure Bank to provide financing to support the construction of new, affordable rental housing for middle- and low-income Canadians.

This does not appear to conflict with the profitability of Genworth MI. But one can never depend on any new majority government to stay strictly within their platform points!

Bombardier bailout

Bombardier reported their financial results on October 29, which were ugly as expected – they bled through about $315 million cash on the operating side and a gross $500 million on the investment side for the 3 month period.

This and the next quarter should be the the worst of it.

There are a few tail-winds now that will make an investment in their preferred shares likely to pay off beyond the receipt of dividend coupons.

I did not mention this in my July 29th post, a strong component of this investment is due to the political factor – the Government of Quebec, and now by extension by virtue of the Liberal Party’s recent victory nationally, the Government of Canada is not going to let Bombardier fail due to the political connections existing between the controlling shareholder and the government apparatus.

In other words, the company will not fail due to liquidity concerns alone – it may fail due to simply being unable to produce a jet, but it won’t be for financial reasons.

Bombardier took a billion dollars from the government of Quebec for a half equity interest in the liabilities of the new jet they are producing. They also issued 200 million warrants to purchase Class B shares at a strike price that is a premium of approximately 50% above the existing market rate – which would dilute shareholders in the event that things went well.

Examining the market reaction (which on net was rather mute), the BBD.PR.C issue, in particular, is trading at an increased yield, presumably due to conversion threat (they can be converted into BBD.B shares at the higher of 95% of market value or $2/share – and at current market prices, this means 12.5 Class B shares per preferred share).

The short end for Bombardier’s bond yield curve also came down – with their new term issue (March 2018) suddenly trading at par from about 94 cents a month earlier.

The new federal government is sworn in on November 4, 2015. It is virtually certain the new government will table an interim budget measure that will announce the easy to implement campaign platforms during the past election campaign – ratcheting down TFSA contribution limits, adjusting marginal tax rates for middle income earners, creating a new tax bracket for high income earners, etc. But one of the early decisions the new government will face is whether they wish to throw some money at Bombardier. I do not believe a federal investment is likely right now (just simply due to transition and the lack of immediate political necessity), but it remains a distinct possibility in the 2016 budget which will probably be tabled around February or March.

The Quebec investment is on the equity side – and preferred shareholders should benefit from this transaction.

I find it very difficult to believe at this juncture that Bombardier will suspend dividends on their preferred shares and they will muddle their way through what has been a financially disastrous investment in the C-Series jet.

The preferred shares continue to be a high risk, very high reward type investment if things proceed to fruition.

A short squeeze on Bombardier

Back on July 29th, I posted I had purchased preferred shares in Bombardier. I wish I had started my averaging a couple weeks later (did pick up a few on the dip), but nonetheless what I expected to happen has happened over the past week, especially over the past couple days.

The catalyst (or rather the assumed story to cause all the excitement) was that a “crown corporation” in China was interested in purchasing lump-sum the rail division for a huge amount of money (enough to pay off nearly all the debt the company had).

While this may be the cited story, the reality is that sentiment was horribly depressed in the marketplace for a company, while clearly having operational issues, that was punched well below what should be a fair valuation range. It took a catalyst event for the mindsets of the traders, investors and institutions to re-value the company in-line to something that was more reasonable.

There will likely be a few slip-ups in the preferred share pricing between now and over the next year, but anybody picking up preferred equity is likely to receive their stated cash flows for quite some time to come.

While in general I think the market is still not showing many investment opportunities (at least from my eye), this was a rare opportunity in a very well-known Canadian TSX 60 issuer in the large-cap space (or at least they were large cap before this all began!). I very rarely dip my toes into the large cap sector.

The bond yield curve has also taken a similar descent.

If my nominal scenario comes through you’ll see the preferred shares at around a 7.5-8.0% yield range in a year. This will be about $20 for the BBD.PR.C and $9 for the BBD.PR.B series (interest rates are still projected to be very low going forward), which represents another 50% capital appreciation or so for much less risk (albeit slightly less reward) than the common shares.

I remain long Bombardier preferred shares.