Zarlink hostile takeover

Zarlink Semiconductor (TSX: ZL) is facing a hostile takeover bid. I have no idea whether investors should sell the equity or wait for something sweeter, but the relevance of this for me was that when I was looking at companies to invest in during the peak of the economic crisis, Zarlink debentures came on my radar screen. The debentures were trading at about 40 cents on the dollar back then, while the underlying company was not terribly profitable and seemed to be going along the wrong trajectory.

I was also concerned back then that you had a company which had a market capitalization that was a low fraction of the debt outstanding which would have made capitalizing the debt more difficult if the company went down that route (like Arctic Glacier, which will be condemning its unitholders to dilution purgatory at the end of July).

In retrospect, the decision to not invest was bad compared to some entities I did put my money in, but back in the middle of the economic crisis, capital was scarce and I made other investment decisions. Zarlink was a close candidate but barely did not make the cut.

Now when you look at various investments, the potential returns for risk is depressingly low. Back then you didn’t need to take much risk to get a very handsome potential reward. Today those risks are much, much higher.

Petrobakken short squeeze

For other articles I have written about Petrobakken, you can click here.

A lot of people are asking “Why did Petrobakken go up 14% in a day?”.

The quick answer is because this is a classic short squeeze, fuelled by a cascade of stop orders taking the stock up higher.

We have the following 6-month graph:

Nearly everybody that has invested money in the company is sitting on a losing position. Conversely, those that were short Petrobakken are sitting on money. In order for short sellers to maintain their fraction of PBN, they must be able to add to their short positions. Short interest in PBN has been about 3 million shares since October and about 4.8 million shares in June. Short interest in Petrobank (which owns 59% of PBN) has also been proportionately higher, so one can’t automatically assume that the short position in PBN is hedging off ownership in PBG.

Eventually there has to be a spike as marginal short players have to cover their tracks – it is nearly impossible to tell when this happen, but when they do, the liquidation is swift and sharp:

PBN continues to trade above my fair value estimate and I will continue spectating as I have no position in this or PBG. My guess, from a trader’s perspective is that there is a good probability that we will see one other sharp spike up and then the shares will continue their steady descent down to fair value. The valuation mismatch between today and what it was a year ago, however, is much less than when the shares were trading at $25. The company also still has the material financial issue of figuring out how to spend more money and issuing dividends beyond the cash flow coming in.

Bank of Canada sending out a warning signal

The Bank of Canada kept their target interest rate steady at 1%, but ominously sent out a signal as follows:

Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be withdrawn, consistent with achieving the 2 per cent inflation target. Such reduction would need to be carefully considered.

The Greenspan-esque interpretation of the tea leaves will point out that prior wording stated “eventually will be withdrawn” while this press release states that it is approaching if the rest of the financial world does not implode.

When reading the more detailed Monetary Policy Report, two charts came to mind:

Total CPI is increasing significantly – it is no surprise to hear this as commodity prices continue to shoot up like a rocket and prices are passed along the supply chain.

Finally, BAX futures shot down for the year-end interest rate – at 98.46 (1.54%) compared to 98.61 a week ago. This is projecting a near-certainty of a 0.25% rate increase by years’ end.

If short term interest rates rise and the yield curve continues to flatten (10-year rates are still at 2.89% even after the bank rate announcement), this will start to have interesting effects on “yieldy” equities as the leveraged bet starts to become less profitable. There are also implications for the real estate market that I won’t be getting into at this time.

Shaw and Netflix – Bandwidth vs. Content

This is probably old news to a lot of people, but I’m awfully curious how the competition dynamics between Netflix vs. the bandwidth providers (e.g. Shaw/Rogers/TELUS) will play out. Shaw announced a streaming movie service recently.

I look at a company like Netflix (Nasdaq: NFLX) and ask myself how many more legs the company has before it starts to hit a competitive wall like TiVo (Nasdaq: TIVO) did.

I’m not going to call winners here, although I am quite aware that it is necessary for bandwidth providers to exist in order for companies like Netflix to exist; the question is where is the most profit to be obtained in the value chain? Is it about the bandwidth, or the content?

The biggest pure play on bandwidth has to be Level 3 (Nasdaq: LVLT), which has successfully been losing money since its history and is a darling of Southeastern Asset Management and the Canadian Berkshire-equivalent, Fairfax (TSX: FFH).

Time will tell, but I’m sticking to the sidelines.

Microcap fishing – Audiotech Healthcare, Spot Coffee

I have spent the better part of the day doing some screening and research on microcap companies (generally those with market capitalizations of under CAD$50 million). I discarded most of the energy and mineral-type firms as these firms are generally impossible for third-parties to get any sort of edge on.

Finding good microcap companies reminds me of the process of mining for bitcoins – you can spend hours (and days) doing it, but still end up with nothing. That was pretty close to what the last half day of my life feels like.

When doing some intermediate analysis on 9 companies, one managed to clear the necessary thresholds for “interestingness” on my watchlist, although this was not a case that screamed at me as a company that will see 5-fold increases in its equity prices. It would be considered a value play. I set a price target that was roughly 20% under what it was currently trading as this would be a valuation that I would be interested in doing some more extensive due diligence for a potential purchase (although it would be a small allocation if it ever got to that point). I will receive an email if it reaches this price threshold.

However, there were two interesting “discards” that I will share.

The first company is Audiotech Healthcare (TSX: AUD), which operates a few hearing clinics in more remote areas of BC, Alberta and the USA. They are family run and family-controlled and stable and profitable. Their balance sheet is in OK shape, with sufficient cash on hand to cover upcoming debt maturities and otherwise not polluted with massive goodwill (indeed, none). Management is relatively respectful of shareholder value (likely due to its significant economic interest in the company) and related party transactions are at an acceptable level (the worst of it is a dead real estate lease in Calgary which will likely be off the books soon). Valuation is relatively cheap, with recent business performance in the last fiscal year producing $347,000 in free cash flow on a (undiluted) market capitalization of $2.38 million. They are ripe to go private or to be consolidated by a larger player.

Unfortunately, their shares are completely illiquid. With $10,000 in volume traded over the past 30 days, a single trader can probably take the stock price up 50% in a day. Hence, this company is in the “interesting but not practical” list of investment candidates.

The next company that I had to do a double-take on is a little more strange. Spot Coffee (Canada) (TSX: SPP) operates coffee franchises, not too dissimilar from Blenz, Waves, Second Cup and Starbucks, in locations in Western New York state, Toronto and one location in Florida. The only difference is that they appear to be larger scale than the typical Starbucks chains and they also serve slightly more complex food offerings.

What is particularly strange is that when you read the management/director biographies, you ask yourself “What the heck are these people getting into this business for?”. I will post the following from their most recent management information circular and let you come to your own conclusions:

The company itself seems to be financed mostly with equity, with the company raising equity capital through private offerings as the need arises. The last private placement was at 10 cents per share for $500,000 and warrants to purchase shares at 15 cents a piece expiring in 3 years. The current market value is $8.6 million and 13.5 cents per share. Operationally they are losing money, but this is due to the lack of economies of scale associated with having such a geographically dispersed operation and relatively low numbers of operating coffee shops.

Gross profit margins have been improving – the most recent quarter being 73%, which is a good improvement over the previous year. Presumably if they manage to scale up their sales in other locations they can actually start to make money, but I haven’t bothered doing the breakeven calculations. This is investing in an industry that is already well established.

Although I won’t be touching the equity on this company, something makes me suspect that this company might be the recipient of some “hype valuation” if they continue opening more stores, sort of akin to Caribou Coffee (Nasdaq: CBOU).

That concludes my investment research for the day – little to show for it.