Interest rates show nothing exciting

Government 10-year bond yields are sitting at 2.95%:

December BAX Futures are at 98.61; with the current 3-month banker acceptances at 1.20% (98.80), there is a moderate expectation of a 0.25% rate increase. However, I do not believe this will come to fruition and it is highly likely the Bank of Canada will continue to keep the short term target rate at 1% until such time that 10-year yields rise above 3.5%.

Since the markets are awash in liquidity and credit is very cheap, investors will continue to chase yield. When will this party stop? If I gave you a million dollars for 10 years at 2.95%, do you think you can do better? I’d take all the money I could at that rate and fixed term.

Keeping currency conversions factored

It should be on the back of an investor’s mind that the appreciation or depreciation of US currency is a significant factor in commodity pricing – as the US currency as depreciated significantly over the past 10 years, this has lead to disproportionate increases in commodity prices when you scale the charts for Canadian currency. Over the past year, the Canadian dollar has scaled up 10% against the US dollar:

When looking at increases in gold and oil pricing, the change is less dramatic when priced in Canadian dollars:

Spot WTIC Crude in Canadan Dollars
Spot gold in Canadian Dollars

I have been looking at my US dollar exposure and have generally asked myself why I have kept any exposure at all and simply not hedged myself. One reason is that I don’t have a clue how to predict currency movements. There always seems to be more variables at play than one would typically think (interest rate, economic, stability, geopolitical factors to name a few). The other reason is that Canada does 75-80% of its trade with the USA. As long as we have this much economic exposure to the USA, the US currency will always be a relevant factor in a Canadian’s life.

Finally, one might actually think there will be a faint hope and that the USA will get its own domestic economic act together. I know such thoughts are stunning and frightening to even assigning an above-zero probability.

Arctic Glacier – Melting down

A couple weeks after Arctic Glacier (TSX: AG.UN) announced it was diluting existing shareholders roughly 90% by converting $90M of convertible debentures into equity on a company with a (then) $14M market capitalization, they now announced that because of cold weather, sales in the second quarter were low enough to breach their loan covenants for their credit facility.

The company is laden with debt – $90M of convertible debentures outstanding (and will be cashed to equity at the end of July), and approximately $194M in term loans that are first and second-ranking.

I will anecdotally state that to my vantage point in southwestern British Columbia, that this spring has been the coldest I have felt in a long time. While I do not need to purchase ice by virtue of my ownership of a freezer, I have not had the urge to do so for outdoor recreation either, and suspect that many other people are in the same boat. Fortunately for the company, it does business outside of southwestern British Columbia.

Even when you wipe out the convertible debentures and convert them into equity, the term loan leaves a crushing amount of debt for the company given their operations. Their highly seasonal nature makes cash flows lumpy so you have to look at the annual statements to get a good comparison. Operationally the company has seen its cash flows decline significantly over the past few years and it is no surprise that the common shares are trading very unfavourably – 28 cents currently.

This is clearly a distressed situation and the term loan lenders can choose to be very unfriendly to the company. What is likely to happen is that the term lenders will receive some equity stake in the company in exchange for an extension or easement of the loan covenants, coupled with a higher interest bite. Equity investors should be cautious in doing the appropriate calculations to see if there what margin of error they have.

The lesson to be learned here is that when you invest in companies that are heavily capitalized with debt rather than equity, you will run into these sorts of problems eventually if there is any variability in the company’s operations year to year. Investing in the equity of such entities is a high risk proposition and such investment should be compensated appropriately with a high potential reward if things go right.

I have no position in Arctic Glacier, nor do I intend to start any.

FLIR Systems – cooling down

FLIR Systems (Nasdaq: FLIR) is a company that specializes in infrared imaging. Normally I do not examine Nasdaq 100 firms, but given that I have been doing a lot of research on military-related investments this one struck up on my radar some time ago and I did some research on it before putting it on a watchlist.

Yesterday, they announced that their expected revenues and earnings would be under what they had previously guided ($390M revenues for the quarter vs. $410M expected; $0.35 EPS compared to $0.38 EPS expected) due to a slowdown in their government product/services division. They are trading down about 11% from the previous day although you can reasonably infer that well-informed investors caught wind of this between May and June this year.

FLIR’s technology is widely utilized. The company made its breakthrough when it got into the civilian infrared imaging market (opposed to strictly military) and this has opened up new markets. The company is now bound by the law of large numbers with respect to its revenues, so it should generally be considered to be a leading player in a maturing industry. It is still trading a valuation which projects ample growth in the future, but a sign of the maturity of the industry was perhaps when the company decided it was going to declare quarterly dividends earlier this year – currently they are at 24 cents per share per year.

Most good companies have periods of time where their stock prices go through significant corrections before they lead their way up again – purchasing such companies when they go through corrections and temporary operational setbacks is how one outperforms the marketplace. Markets love to extrapolate growth way out into the future, and they also like smoothness of earnings and revenue growth curves – any hiccups along the way and the market loves to punish these companies.

On the flip side, investors in companies that have most of their revenues derived from US government entities should be somewhat worried about the US fiscal situation.

The usual disclosure is that I have no position in FLIR, nor am I interested in it even at existing valuations.

Analysis of Rogers Sugar

I notice that a couple weeks ago Susan Brunner did an analysis of Rogers Sugar (TSX: RSI) (Part 1, Part 2). I generally like reading what Susan writes simply because she is very rigorous and quantitative. I am pretty sure that she does some more digging “underneath the hood” in the companies she profiles.

In the event of Rogers Sugar, I have been an investor in units since 2007 when it was still an income trust. I added significantly to my position during the 2008-2009 economic crisis. Although I have trimmed my position somewhat early this year, RSI is still a significant holding in my portfolio and I do not anticipate this changing unless if there is appreciation in the share value from current prices. The company is currently trading slightly above the upper end of my fair value range.

There are a few salient details which looking at the balance sheet and income statement will not bring up in a cursory analysis. This requires some knowledge about their business model. The company imports raw sugar cane (typically from Brazil) and also produces its own sugar beets (in Alberta) which is manufactured into sugar in its Taber, Alberta facility. Sugar cane is manufactured into sugar in Vancouver and Montreal.

The company makes extensive use of hedging to shelter volatility in cost inputs, particularly raw sugar and natural gas. As a result, due to GAAP accounting practices (and IFRS, which makes statements even more difficult to read) income streams are very volatile as contract values rise and fall. This makes quarterly income figures almost meaningless to compare from quarter to quarter and has little to do with the economic performance of the company. As a result, management provides in the MD&A documents an “adjusted gross margin” figure which is much more comparable from quarter to quarter. An example of the most recent quarter is as follows:

Q2-2011 was not very good, but volume has been relatively steady from 2010. The reason for the lackluster performance is because management has had a difficult to managing the volatility of sugar prices (see below):

Overall performance has also been hampered retrospectively from its full potential by management hedging natural gas pricing in an environment where spot pricing has been significantly cheaper than pricing a year or two out.

The company is in a duopoly situation with another major competitor in central Canada, and one other minor competitor. There is no real competition in the western half of the country. This, combined with adequate protection against international sugar trade (duties for US sugar imports make US competition prohibitively expensive) make Rogers Sugar economically very stable to invest in. There are signs of erosion from free trade agreements in Latin American countries and possibly the European Union, but so far this has not materialized and such threats have been present for a very long time. Despite its economically sheltered position, margins are relatively slim – 2010’s fiscal year had a 7% after-tax profit margin with the assumption that the income was fully taxable (the income trust structure sheltered most of the taxation until the end of 2010, but the statements have retrospective treatment of income tax provisions for comparability).

Finally, the company has $78M of 5.9% convertible debentures outstanding (TSX: RSI.DB.B) that mature on June 29, 2013. They are convertible into shares at $5.10, or about 15.3 million shares. The company has the right to call them at par value at any time (with 30 days notice). While the company should have no problem refinancing the debt, the overhang will likely serve as a drag on further share price appreciation. For the company, it also brings up a cost of financing issue since the interest bite on the debentures is $4.6 million per year pre-tax, while if converted the shares will pay an after-tax dividend of $5.2 million (and at a 25% stauatory tax rate, that translates into $6.9 million).

As sugar prices have continued to remain high, if the company is able to harvest its sugar beet crop in sufficient quantity, there would be a boost to gross margins and this is likely somewhat reflected in the existing stock price. It is likely that while there is some expectation of this already baked into the price, it is probably not priced in fully yet. If you have read this far, this is a predictive comment and actionable information if you care to speculate.

Management is very experienced in the industry and the key/controlling shareholder (Belkorp Industries, run by Stuart Belkin) owns a 12% stake in the common shares (but has the right to nominate a majority slate of directors in the operating company) and there is sufficient alignment of interests with non-controlling shareholders. Management compensation is fair, aligned to performance, and dilution has been kept to a minimum. I am surprised that the company hasn’t been taken private in a leveraged buyout when unit prices were lower, but at present prices this is not likely to happen.

While the company should have no problem paying out their cash dividend, given the nature of the industry, one would not want to hold onto Rogers Sugar if they are expecting a double in the price of their shares. Hence, Rogers Sugar is not a growth company, but rather a very stable income producer held in a non-registered account.