Credit coming to a crunch

It is quite evident looking at bond trading that credit is coming to a halt, very quickly.

First of all, I notice debentures on various firms are plummeting – most of the underlying companies have lots of refinancings ahead in order to make it through. An example of this is Data Group (TSX: DGI.UN), which has had its debentures trade down to 60 cents on the dollar.

Sterling Shoes (TSX: SSI) announced they will not be making their interest payments on their debentures, effectively putting them in default – their interest payment is due on October 31, 2011 and will subsequently lead to a potential default sometime in November according to their prospectus (if enough debenture holders are able to declare a default).

Superior Plus (TSX: SPB) was lucky to get off a $75M debenture financing (with a 5-year term at 7.5%) in the middle of September before their common shares started to fall off a cliff – and took the debentures (series C, D, E, F) with them. Superior Plus is no stranger to this website, having predicted a dividend cut in the past.

Yellow Media is no stranger to this site either, but since I am still licking my wounds on this one, I will leave it at that with this company. Similar to Superior Plus, however, both companies are still free cash flow positive.

First Uranium (TSX: FIU) has had some serious issues regarding their operations and financing, and also some political risk thrown into the mix. As a result, its secured notes have traded down. Indeed, when looking at the management projections for the July to September quarter, management has projected they will be left with about $9 million cash on their balance sheet before they can make a (what they think) turnaround – instead, they just might be ready to default since they also have a CAD$150M debt payment on their unsecured debentures due June 2012. First Uranium is also no stranger to our site, having had the misfortune of investing in their notes and debentures in the past.

Finally, Connacher Oil and Gas (TSX: CLL) has had their common shares annihilated over the past couple months – their unsecured debentures are due on June 30, 2012 and are now trading at 85 cents on the dollar. This is quite interesting in light of the fact that the rest of the company’s debt is structured out until 2018 and they have set up a credit facility to be able to pay off these debentures. The risk is that the company will simply convert the debentures into equity and you end up with another Arctic Glacier (TSX: AG.UN) which underwent a lot of dysfunction after they did the same thing with a very low stock price. Those debenture holders would have been lucky to realize half the value of their debt, or if you timed it perfectly and had a small amount of debt to work with, about two-thirds.

A lot of credit-sensitive companies are trading lower. It is difficult to tell when it will end, but an investor picking up the scraps of companies that will, through organic business performance, be able to bounce back will be very rich – similar to how anybody investing in the corporate debt market in early 2009 made out very well.

Timing indeed is everything.

Petrobakken – plunging down

While I have been losing a small amount of money on Yellow Media’s preferred shares jaunt to zero, fortunately I have steered far away from Petrobakken (TSX: PBN) which I have written here many times before.

They will not have an easy time renewing their credit facility which expires on June 3, 2012. The debtors are clearly in control of this one, just like how they are in control of Yellow Media. There is $1.14 billion in bank debt at the June 30, 2011 quarterly report. Another looming timeline is a US$750M debenture which holders have a put right – they give notice in December 2012 and the company must redeem at February 8, 2013.

(Update, September 29, 2011: Apparently they managed to renew their credit facility with an extra $150M in the facility… oops! This was announced in their Q2 financial update, which completely escaped me – this kind of blows a hole in the immediacy of cutting the dividend in the subsequent analysis, but there still remains a significant debt renewal of US$750M that will be taking place in February 2013).

From the MD&A, August 9, 2011:

As at June 30, 2011, PetroBakken had $1.14 billion of bank debt drawn on our $1.35 billion credit facility. Our credit facility is with a syndicate of banks and has a maturity date of June 2, 2014. The amount of the facility is based on, among other things, reserves, results from operations, current and forecasted commodity prices and the current economic environment. The credit facility provides that advances may be made by way of direct advances, banker’s acceptances, or standby letters of credit/guarantees. Direct advances bear interest at the bank’s prime lending rate plus an applicable margin for Canadian dollar advances, and at the bank’s US base rate plus an applicable margin for US dollar advances. The applicable margin charged by the bank is based on a sliding scale ratio of PetroBakken’s debt to earnings before interest, taxes, depletion, depreciation and amortization (“EBITDA”). The facility is secured by a $2.0 billion demand debenture and a securities pledge on the Company’s assets. The credit facility has financial covenants that limit the ratio of secured debt to EBITDA to 3:1, limit the ratio of total debt (total debt defined as facility debt plus the value of outstanding debentures in Canadian dollars) to EBITDA to 4:1, and limit secured debt to 50% of total liabilities plus total equity. The Company is in compliance with all of these covenants.

The TTM EBITDA is $659M, thus they are comfortably in compliance with this ratio. You would think the banks would be slightly uncomfortable with lending this much money in a company that is so heavy on capital expenditures.

My immediate guess is that the company will have to seriously curtail, if not outright suspend their dividend until such a time they are able to repay a substantial portion of their credit facility. This is not news to me – I had predicted this in May of 2011.

Another course of action they will likely implement is a slowdown of their capital expenditures. The only consequence of this, however, is that they will not be able to keep up their production levels, which their wells strongly taper off after the first year of drilling. This in turn will hinder their financial results.

The company is also highly sensitive to the price of oil and the past six months of WTIC trading has not helped their cause any.

Even though PBN has been sent down over 50% over the past couple months, it is still trading above my fair value.

Yellow Media restated credit facility – can they survive?

As Yellow Media’s shares (preferred and common) continue their descent to zero, they did release what was in their restated credit facility (attachment).

Notably are the following:

1. Article 8 covenants are fairly obvious – the company must report annual and quarterly statements in compliance with GAAP, etc. There is a reference to budgets and projections (8.1 (c) and (d)) that will likely mean that the creditors will have material information that the public does not have. Probably the same people dumping the preferred shares well in advance of this calamity!

[8.1 (d)] (x) a breakdown of print and online revenues, (y) distributable cash flow and distribution calculations and (z) expected revenue drivers and which projections should be in a format consistent with the September, 2011 Projections.

Also 8.10 requires the company to include more guarantors to the creditor agreement which are subsidaries of the company.

2. Article 9 covenants are more restrictive. They prohibit the taking out of further debt unless if under the credit agreement, except for minor items including capital lease obligations no greater than $25M, and also other minor conditions including intra-company debt;

9.3 prevents the company from acquiring or liquidating companies without being able to satisfy the existing covenants on a pro forma basis;

9.4 requires the company to remit any proceeds above $25M in a sale to the creditors necessary to achieve compliance with covenants on a pro-forma basis;

9.5 is the salient clause – it prohibits distributions to common shareholders (except for the last 2.5 cent common dividend upcoming), but includes the following clause:

(iv) the Borrower may declare and pay dividends on the preferred shares of the Borrower existing as at the date hereof,

This would suggest, as long as the company can make its other covenants that the preferred shares will continue paying dividends.

The important covenants, the performance-related ones, are the following:

9.7 Consolidated Total Debt to Consolidated EBITDA Ratio
The Borrower will not permit the Consolidated Total Debt to Consolidated
EBITDA Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be greater than the ratio of 3.50 to 1.

9.8 Consolidated EBITDA to Consolidated Interest Expense Ratio
The Borrower will not permit the Consolidated EBITDA to Consolidated Interest
Expense Ratio for any Test Period beginning with the first Test Period ending after the Closing
Date to be less than the ratio of 3.5 to 1.

9.7 is a stronger covenant than 9.8; using the first half of 2011 results as a measure of these two, the company’s ratios would be as follows:

9.7: EBITDA (12-month extrapolated, realizing this is a flawed extrapolation) $366.5M*2 = $733M, debt at June 30, 2011 is $2.39B, for a ratio of 3.26:1. There was a large amount of debt paydown for the Trader Corporation sale, but the larger risk is the EBITDA number.

9.8: EBITDA: $366.5M for the first half; $84.6M in financial charges for the first half, for a ratio of 4.33:1; the financial charges going forward will be less due to the repayment of MTN’s, but the obvious risk here is the decreasing EBITDA;

The raw math boils down to the following: Can YLO keep its head above the EBITDA water? With the Trader Corporation sale, the company will have about $1.7B in debt to worry about, which means that its ultimate concern is being able to generate about $480M in EBITDA on an annual basis (or less if it continues to pay down debt). At present when you extrapolate the trajectory that its EBITDA is declining (2009: $903M, 2010: $860M, 2011: $366.5M in the first half), can they level it off at about 40% less than its 2009-2010 run rate?

If so, the company can survive its credit facility. If not, there will be a default.

High risk, high reward.

The optimistic scenario is if they can stem the decay and be able to survive its credit facility – I would guess that the preferred shares in such a case would trade around $17-18 if there is clear evidence that this is happening. Obviously we do not see any of that evidence currently and the next quarterly report is just as likely to be brutal.

Students of history will also remember that when Nortel was going through its preliminary death throes in 2002, they were contemplating restructuring and their preferred shares went down to about $1-2 before finally coming back up again. I remember that quite distinctly although I never purchased into Nortel preferreds back then. The analogy is not appropriate to this case (different business, different situation) but what is salient is that low prices give high risk, high reward type situations – there are many scenarios where it is likely that the preferreds of YLO will go to zero, but there are plausible cases where they will rise again.

This is why you never ever put significant fractions of your portfolio into picks that are high risk like this one – keep the bets tiny. At this point it’s really tough to distinguish between investing and gambling. Just as a point of reference, if you put 2% of your portfolio into a play like this and it goes up 10-fold (which the low-probability winning scenario is for the preferred shares if the company actually manages to get its act together), that 2% position will be a 20% position at the end of the day if you do not rebalance.

Just remember the likely scenario is that the 2% goes to zero!

Got my hands bloodied up catching Yellow Media

As I alluded to in an earlier post, catching plunging knives (in this case, catching plunging share prices) will leave your hands bloodied, and indeed this has been the case with Yellow Media.

They announced this morning that they will be suspending their common share dividend and also will be reducing the size of their credit facility to $500M, of which $250M will be paid off at $25M/year from the beginning of 2012 onwards.

This caused their common stock to plummet, but oddly enough, caused their preferred shares to drop equivalently, to the tune of 50%.

PR.C shares are down to $3/share, while PR.D shares are down to $3.08/share.

By slashing the common dividend, they will save about $77M/year in cash flow.

With the common share dividend gone, it will remain an interesting decision whether the company will decide to cut preferred share dividends. PR.A will cost the company $10.7M/year, but this will be alleviated when they convert them to shares in April 2012. PR.B will cost $7.6M/year, but this will also be alleviated when the company force converts them in July 2012.

PR.C is the next drain on cashflow – $13.2M/year, and PR.D is $8.5M/year. Both of these series are cumulative and can only be called by the company at par ($25) which is obviously not going to be happening with them trading at $3 over the open market.

The debentures are trading at 32 cents and represents a $13M/year interest expense for the company – these interest payments must be maintained otherwise it will constitute a default – a 20% current yield, but how long will you see those coupon payments being paid?

The real question is: how quickly is the company’s cash flow diminishing? This “decay rate” is the critical variable in determining how financially viable the company is going forward.

The company’s preferred shares are obviously a very high risk and high reward type situation if your assumption is that they are not going bankrupt and they will be able to level off their cash flows at a positive amount.

Berkshire and commodities

Two observations – Berkshire announced that it will repurchase its own shares at no more than a 10% premium to book value. The stock went up about 8% in trading during the session to roughly this level. Book value is $163 billion, while the company has 1.649 million class “A” equivalent outstanding for a book value of about $98,850 per share. Add 10% and this gives a value of roughly $108,700 per share, not too far from the closing price.

I find this interesting simply because Warren Buffett is now a net seller of his own company and he is quite good at using his mouth to talk up or down the market when it suits his purposes – there tends to be a media aura that he is relatively altruistic. I am not convinced that Berkshire makes a compelling value as its analysis is not that easy – essentially an insurance operation with a series of fully-consolidated subsidiaries and a hodge-podge smattering of equity in various well-known companies (including Burlington Northern). When at the scale of Berkshire, the rules of engagement are considerably different since it takes forever to build and exit positions – not as easy as plugging in a market order to buy 100 shares of Microsoft.

The last time Buffett talked about buying back his own shares was when it was trading at $40,000 at the peak of the tech bubble. He graciously offered anybody that was willing to sell at that price can call him up and sell it to him at the prevailing bid on the NYSE at the time. Nobody took him up on that offer.

The other observation is commodity prices appear to have developed a “spike” on the charts. Observe the following:

Although I am hardly a technical trader, my best guess at this time is that the three commodities will head up for the rest of the week or so before declining again and “retesting” the bottom of that spike and likely trending down. There was clearly some sort of liquidation that has been occurring and the market is not that deep.