Gran Colombia Gold’s confusing capital allocation strategy, part 2

Read “part 1” here. Gran Colombia Gold (TSX: GCM) announced their quarterly results a few days ago.

At September 30, 2019, the cash position was at US$63.2 million. There is another US$5.8 million that goes to the noteholders. Total debt is US$91 million (US$73.6 million in notes due April 2024, CAD$20 million in convertible debentures due April 2024, convertible at CAD$4.75). The leverage situation is better than it has been for these guys for ages.

Cash-wise, in the past 9 months, the company has made US$38.7 million in free cash flow (operating minus expenditures on mines, but not including SSP.TO investments). As long as gold remains at current price levels, they should be able to generate cash along these lines.

Now this is where things get wonky.

From June 12, 2019 through September 30, 2019, the Company purchased a total of 137,100 warrants for cancellation at an average price of CA$2.41 per 2024 Warrant.

The warrants have a strike price of CAD$2.21/share. Ignoring the time value of the warrants (which is not inconsiderable), GCM effectively repurchased stock at CAD$4.62/share. If they repurchased the actual common shares, they would have paid less.

On November 5, 2019, the Company closed a non-brokered private placement (the “Private Placement”) with 2176423 Ontario Ltd., a corporation that is beneficially owned by Eric Sprott. Through the Private Placement, Mr. Sprott acquired 3,260,870 units of the Company at a price of CA$4.60 per unit for a total investment of CA$15 million, the proceeds of which will be used for general working capital and corporate purposes. Each unit consists of one common share and one common share purchase warrant exercisable into a full common share at CA$5.40 per share expiring November 5, 2023.

This is just strange and contradictory capital allocation. A few months after effectively repurchasing stock at $4.62/share, they then sell a bunch of it at $4.60. There was no need to raise CAD$20 million in debentures back in April 2019, and there is no need to raise CAD$15 million in November… unless if they’re planning on blowing a lot of money on everything else. Their common stock would likely be higher today if they had not done so.

The notes are very likely to be called out or mature, while the common stock will be quite sensitive to the price of gold.

One other theory that I have is the following, and this is relating to GCM dumping their selling partners late last year:

As described in Note 11a, in January 2019, the Company terminated its long-term supply agreement related to the sale of its gold and silver production in Colombia. On May 10, 2019, the Company received notice of a request to settle the dispute, as permitted under the supply agreement, under the Rules of Arbitration of the International Chamber of Commerce. In its notice of arbitration, the former customer has requested reinstatement of the supply agreement and damages related to the intervening period since the supply agreement was terminated. In the alternative, the former customer is claiming general damages in the amount of $50 million, or such other amount as may be determined prior to or at the arbitration, punitive and/or exemplary damages of $1 million, repayment of $0.2 million of disputed interest and reimbursement of costs and expenses related to the arbitration. The Company believes as a result of breach of performance by the former customer on numerous occasions that it had a justifiable basis for terminating the supply agreement and will vigorously defend its position in the arbitration proceedings. The Company believes that it is more likely than not that it will not have any liability from arbitration.

If the company has a 49% probability they will have liability (which is “more likely than not it will not”), they might have a justification for assembling a bunch of cash – much better to have it on hand to pay out instead of scrambling into the markets with your hand stretched out!

The end of Temple Hotels

Temple Hotels (TSX: TPH) is finally going to be removed from the public markets for CAD$2.10/share by majority shareholder Morguard (TSX: MRC).

Temple has been the target of a slow motion takeover which, in 2015, was effectively finalized by Morguard by the assumption of its asset management agreement, and repurchase of debt securities. After, they proceeded to raise capital through rights offerings which resulted in Morguard accumulating a 73% stake in the company. An entity associated with Clarke’s (TSX: CKI) Armoyan, owns 17% of Temple and agreed to be bought out by this price.

I said a long time ago I was wondering what the heck Morguard was doing meddling with Temple given Temple’s financial statements – even after injecting a bunch of equity capital, the company still appears to have sub-standard financial metrics. Four years after this slow motion takeover, my thoughts still persist. It’s one reason why I wasn’t exactly looking at the prospect of buying equity at CAD$1.80/pop, which was the trading price it was very thinly trading at for most of this year (heaven forbid if I was forced to participate in another rights offering).

Statement on Brookfield Asset Management and its family of subsidiaries

Too complex. Bruce Flatt is undoubtedly a genius (in John Malone style), but compare Brookfield with the relative simplicity of Berkshire (despite Berkshire controlling a much larger asset base) and there is such a huge night and day difference. My general issue with large conglomerates with lots of partially owned but controlled subsidiaries is that you run into agency issues with the boards having common members, but having to guess which arm of the company is going to be advantaged (or whether it mostly flows to management).

So a long time ago, I excluded Brookfield and its subsidiaries from being investment candidates – too difficult. I’ve always taken a superficial liking to Brookfield Property Partners (TSX: BPY.UN) (their takeover of General Growth was well timed), but even that entity has a snake’s pit of issues relating to structure. There’s a whole bunch of other REITs trading on the TSX (and indeed the NYSE) that give property exposure with a lot less complexity.

The DREAM preferred share comes to an end

Dream Unlimited (TSX: DRM) had a class of preferred share (TSX: DRM.PR.A), which by virtue of their split from Dundee Corp (TSX: DC.A) had an unusual characteristic – it had a par value of $7.16/share, and was redeemable by the company or the shareholder at any time. In the meantime, it paid out a quarterly coupon of 12.53 cents per share, or 7% on par. The company retained an option to redeem the preferred shares for their own stock at 95% of a prior trading range of DRM stock or cash (or a $2 floor).

This preferred share has been trading for quite some time, and by virtue of DRM’s relatively stable balance sheet, was never in threat of suspending its dividend.

As such, yield-hungry investors could use this preferred share as a cash parking vessel. Even better yet, the dividends that were paid were eligible dividends which would qualify for the dividend tax credit in non-registered accounts. Over time, however, DRM.PR.A became over-utilized and started to trade at a significant premium to par:

The peak was on August 31, 2019 when some poor soul paid $7.56/share for this, or a 40 cent per share premium over par value. This investment would have taken over three quarters of dividends in order to pay itself off. Indeed, at this price the current yield would have been 6.63% for a perpetual investment.

All good things, however, come to an end. Today, DREAM Unlimited announced a substantial issuer bid on their common shares and also the following paragraph:

The Company also intends to redeem all of its outstanding First Preference shares, Series 1. As at November 11, 2019, there were 4,005,729 Preference shares, series 1, issued and outstanding. They may be redeemed at the option of Dream, at any time, at a price of $7.16 per share, plus all accrued or unpaid dividends up to but excluding the redemption date.

As such, one of the best cash parking vessels on the TSX will be off the ledgers. I would expect the shares to crash 4% tomorrow in trading. Fortunately I sold the last of my DRM.PR.A in 2018.

To my knowledge, there is only one other financial instrument that trades in a similar manner, which is Birchcliff Energy’s preferred shares (TSX: BIR.PR.C) which are redeemable by the holder as of June 30, 2020. They also give out a 7% coupon. They are also trading above par. Although the premium is very modest at present, when adjusting for the dividend dates it effectively makes these shares at a tiny discount. There is more balance sheet risk with Birchcliff given its spacing in the natural gas industry, hence why it is not trading wildly above par value at present, in addition to a potential share conversion price at a floor of $2/share (Birchcliff common closed at $2.21 today). I’ve held some of these since February 2016.

Why Marijuana producers will all go to zero

Here’s an interesting press release from a marijuana producer company Alefia (TSX: ALEF, ALEF.DB) – the relevant snippet I’ve quoted below:

2019 OUTDOOR HARVEST HIGHLIGHTS

10,300 kg of dried flower harvested
1,000 kg per acre yield in Zone 1, which was planted in June 2019
$0.08 cash cost per gram to harvest (unaudited)
$0.10 all-in cash cost per gram to harvest, including facility capital costs (five-year amortization) (unaudited)
Cannabinoid content (THC and CBD per gram) of harvested flower was strong, at levels near to the cannabinoid content in identical strains harvested indoor
Quality assurance testing to date is successful, including for microbial content, pesticides and contaminants

“Our inaugural 2019 outdoor harvest was successful due to the commitment and capabilities of our team. I’d like to thank our on-site growers who navigated the challenging environment of starting the cultivation season late into the year and ultimately delivered an excellent harvest that we are measuring in tons,” said SVP of Production Lucas Escott.

The key line here is the $0.10 per gram “all-in” cost per gram to harvest, which bakes into some “half-baked” amortization scheme (pun most definitely intended).

Simple math follows.

1 kilogram (kg) is 1,000 grams.

So this batch of 10,300 kg of dried flower marijuana cost $1.03 million using their numbers.

How much is 10,300 kg?

Apparently 5.2 million Canadians have consumed cannabis over the past three months.

Consumption statistics are not that easy to find, but apparently in 2017 (when Marijuana was still technically illegal in Canada) the annual consumption was about 20 grams per user (with the distribution of consumption highly skewed towards the high frequency user in a typical Pareto distribution – I’d argue that these people are more likely to have their own sources, but let’s ignore this for now). This works out to 104,000 kg per year of consumption (if legal).

The latest statistics (link 1 – October 2018 to June 2019, link 2 – July and August 2019) show the annualized consumption at around 155,000kg (medical and non-medical usage – the pretense of medical usage has gone completely away after legalization).

So let’s say it is 155,000kg and rising. What I find particularly amusing is that if distributed evenly among 37 million Canadians, that’s 4.2 grams for every man, woman and child – apparently this is good for about 10 joints per individual.

Of course, not every Canadian is going to smoke marijuana. Statistics suggest that about 1 in 6 Canadians use it. The addressable population for Cannabis is about 6 million people in Canada – or about 26 grams per person. Assuming this 1 in 6 number is constant (I don’t see how non-smokers can convert into smokers too easily), that works out to about 26 grams per smoker – how much higher is this going to go?

Later in Alefia’s press release, we have the following:

Based on the 2019 results, the Company estimates that it can produce 1,200 kg per acre for a total of 102,000 kg of dried flower in 2020 at its expanded 3.7 million sq. ft. (86 acre) outdoor site, at full capacity. The modest increase in the expected yield per acre for 2020 is due a number of factors which should improve the overall outdoor grow operation, including commencing cultivation several weeks earlier relative to 2019.

So we have one company that is making a claim they can produce 2/3rds Canada’s annual consumption of (legal) marijuana, and implying they can do it for a relatively low cost (10 cents per gram, all-in).

If this is true, then there are a few implications, especially considering that growing marijuana doesn’t appear to involve much in the way of patent-able or proprietary technology (it is a weed, after all!).

One is that there is going to be a massive over-supply of marijuana, and there will be a huge “race to the bottom” effect as price leaders attempt to leap-frog each other to dump their supply into the market place. This is already happening.

Two is that because the marginal cost of production is effectively nothing, that the value chain in producing is going to capture precisely zero profit beyond a cost of capital – and indeed, that will only happen when other inefficient producers get squeezed out of the market due to oversupply – is the company that is able to produce at 6 cents per gram all-in going to have a competitive advantage when all others can do it at 8 cents? Sure it will, but how much value will they be able to extract from that advantage? Not a lot.

Three is that governments are going to make a huge amount of profit on volumes (one of the winners of the value chain, and also having a huge financial incentive to encouraging as much volume as possible to be transacted in the legal market). (CRA Cannabis Excise Duty Information) At the federal layer, the government stands to make a minimum of $1/gram sold, or 10% of the product cost.

Four is that the low price of producing cannabis is going to create its own markets for ultra-low priced product, but this has to happen before it hits the excise tax layer – hence, the production of oils and other cannabis knock-off products that try to find some way to use what is otherwise worthless biological inventory.

Where is the profit going to be in the product? Obviously it is going to be in branding and marketing like most commodity products – tobacco has its Marlboro, and if/when Cannabis has their equivalent, that brand will probably end up making money. These brands take decades to build, sort of like Coca Cola and Pepsi. Until then, good luck – everybody in the marijuana production industry is going to lose.