Brookfield swallows North American Palladium

North American Palladium (TSX: PDL) operates a mine which has been somewhat profitable, but financing expenses have killed any chances of the overall operation returning money to shareholders.

Balance sheet-wise, they invested $450 million in mining operations, while having a $220 million debt to deal with and a requirement for some cash, which they do not have. A classic case of solvent, but not liquid.

The primary cause of this was doing a deal with the Brookfield devil, where management borrowed US$130 million at a rate of 15% interest in June 2013. The debt was secured by PDL’s assets. Not surprisingly, it has gone financially downhill since then. The debt has since morphed into US$173.2 million as interest has been subsequently capitalized into the loan (and other drama that has happened since that point which I will not get into).

What’s amazing is the corporation somehow managed to find enough suckers to invest in some toxic convertibles in 2014 that significantly diluted the company’s equity but kept enough cash to keep the zombie alive for another year.

Finally, they succumbed to having a quarter of your revenues go out the door in the form of interest expenses and are coming to grips in the form of a recapitalization proposal.

The term sheet (attached) that management came up with to ensure its own survival is quite onerous to all involved.

The salient details are that existing shareholders will keep 2% of the company, unsecured debenture holders will receive 6% of the new company, and Brookfield and partners will keep the 92% after generously injecting US$25 million and releasing their accumulated debt to the firm. Afterwards, Brookfield will float a rights offering where they will raise another CAD$50 million and this will presumably dilute the interests of the then-common shareholders even further if they do not wish to participate.

A holder of 52% of the convertible debentures has been spoken to and agrees to this proposal. They need 2/3rds approval, which is likely considering that the convertible debentures are unsecured and they would receive nothing if the company went through the CCAA route.

Not surprisingly, existing shareholders/debentureholders of PDL took down the price:

PDL.TO share price
PDL.TO share price
PDL.DB.TO price
PDL.DB.TO price

The recapitalization document was released on the morning of April 15, 2015 half an hour before trading opened, so astute traders that could skim through the news release and the actual term sheet would have been able to get out at 19 cents if they hit the opening market trade. If you waited until the end of April 15, you would be sitting at 12 cents.

At 7 cents per share of PDL stock and roughly 400 million shares outstanding, the market is valuing the recapitalized version of PDL at CAD$1.4 billion.

It does not take a genius to figure out that, with $220 million in revenues in 2014, the existing stock price is still significantly over-valued. If I was owning any shares of this train wreck, I’d still be dumping at market. Fortunately I’ve never owned any shares (or debt!) of PDL. Purchasing a mining operation at 7 times revenues is not exactly a value play.

However, the albatross of having to deal with a crushing 15% senior secured loan will be off their backs and the resulting entity may have a fighting chance when it doesn’t have to shell out $50 million a year in interest expenses. You just have to figure out at this point what Brookfield’s incentives are to ensuring they get the most of their 92%+ equity stake in a post-recapitalized PDL.

Genworth MI and Canadian real estate speculation

It is fairly obvious by looking at the graph of Genworth MI (TSX: MIC) that institutions are dumping stock in fears that mortgage default rates are going to spike up as a result of economic calamity in Alberta. The CEO of Genworth talking about “heightened vigilance” isn’t helping matters any.

While this might be true, it appears that other real estate metrics are relatively in tune. My cursory scans of the REIT market (e.g. Riocan, H&R, Calloway, all apartment trusts, etc.) doesn’t show any erosion in that marketplace. Banks (e.g. BMO, BNS, etc.) are showing some equity erosion since the middle of 2014, but I’d suspect this is more due to yield curve compression and partially due to the solvency risk posed by syndicate loans to various oil and gas companies.

Other direct lenders, mainly Equitable and Home Capital, have both seen erosion but it is not significant to the point where one would think there is going to be a complete and utter collapse in the fundamentals.

Genworth MI appears to be the whipping boy in the real estate industry. If such fears are warranted, then one would think that REITs and other related stocks would also get proportionately taken down.

So the question now is whether the market is wrong about REITs or wrong about Genworth. Assuming the negative momentum for Genworth MI continues, one would guess that looking at the financial metrics and historical charts (and then-fundamentals of the company at that time) that it is conceivable the stock can get down to about $22-23/share as a floor. This is based on the discount assigned to the stock during the mid 2012-2013 period and the fundamentals of the company at the time.

Today is a little different in that the company has less shares outstanding and has more equity on the balance sheet.

Assuming the Canadian real estate market does not completely nose dive, an investor would still be looking at around 20% downside on existing technical momentum, but fundamentally there is still significant value as the firm is trading deeply below book value at present (right now at a 20% discount). It is like purchasing a leveraged bond fund at a significant discount.

The combined ratio (this is the loss ratio plus the expense ratio) during the depths of the 2008-2009 economic meltdown, did not go above 62%. Delinquency rates never got above 0.30%. Today, it is 39% and 0.10%, respectively. Yes, these numbers will increase as people start defaulting on their Alberta homes, but I simply do not see at present those numbers getting worse than it was in the 2008-2009 era.

I am watching this carefully and may choose to add to my position.

Pinetree Capital – Redeeming debentures

Pinetree Capital (TSX: PNP) today has announced it is redeeming $10 million of its debentures, at par value plus accrued interest, effective April 30, 2015.

As readers are aware by my previous rantings about Pinetree, their debt has been a remarkably good deal, especially around the 70 cent range, but they are still a reasonable risk/reward at 80 cents. The extra security that was arm-wrestled from management once they blew the covenants is icing on the cake.

Debenture holders will be cashed out pro-rata, which works out to an 18% redemption of debt. I’ll be hard-pressed to find a better alternative for the cash, but I’ll be happy to have it sitting in the bank account until such a time.

The market value of the debentures was bid/ask 80/83 cents and considering the cash-out is at par, this will likely result in an increase in the quoted price for the remaining debentures.

Notable to this announcement is that this is going to be funded by cash on hand, which implies that the company has been doing some liquidation of its non-disclosed holdings (these would be less than 10% ownership stakes in various firms). There has only been a minor trace of activity on SEDI on their 10%+ ownership stakes (the two largest that are publicly known is POET Technologies (TSXV: PTK) and Sphere 3D (Nasdaq: ANY)).

Also notable is that this is the first $10 million of the $20 million that is required to be redeemed by July 31, 2015. Up to half of the remaining amount can be done through open market transactions and also the company has the option of redeeming 1/3rd of its debentures in the form of equity, which has not been the case to date.

Finally, Pinetree has not released its 2014 year-end audited financial statements, but one can assume that they will be able to with this redemption notice. The annual statements are due on March 31, 2015 otherwise very bad things happen to reporting issuers that do not report.

Pinetree must have a debt-to-assets ratio of 50% up until October 31, 2015 and then after that it must be below 33% otherwise it will be in default of its debt covenants (once again). We should get a better view of what may occur once they file their 1st quarter report. Achieving 33% is going to be made much easier once they complete $20 million in redemptions and the question is whether debenture holders are going to receive equity or not (which would likely give debtholders control of the firm).

I’m expecting there will be a reasonably decent chance that investors in the senior secured convertible debentures will be made whole and also be able to collect a 10% coupon between now and the May 31, 2016 maturity date.

Some portfolio activity

It has been an unusual month in that I’ve been nibbling and taking some small positions on some reasonable bargains.

I’ve taken a half percent position in a very trashy penny stock that will most likely go permanently unnamed. This isn’t a microcap play, it isn’t a nanocap play, it can only be called a picocap play. Suffice to say it is illiquid, infrequently traded, but I managed to get a reasonable fill on what I wanted to get and we’ll see if it goes to zero or whether it’ll triple on some business developments which I believe will stand a good chance of occurring over the year. If anything, at least there is a corporate shell that can be sold as a quick TSX listing.

I find rolling over options to be a royal pain in the rear for stocks that have infrequently traded options. The only reason why I’m in options in the first place is because I believe the implied volatility is badly underestimated (trading in the 20’s when it should be closer to the 40’s) which makes the options a more optimal usage of capital than the common stock. When trading options the only problem is timing, and dealing with a large chunk of a barely in-the-money option when there is a month left to expiry always makes me nervous. So I’ve rolled that over into the latest dated options which is roughly half a year later in time for a moderate cost of about 4.5% of the equity price. The cost of purchasing delta is quite cheap on this one, especially when it is trading under book value and they are buying back shares, coupled with a profitable business operation. Quite frankly I expect a takeover bid.

The mechanics of dealing with a barely in-the-money option is made slightly easier with Interactive Broker’s option spread utility which will automatically perform a transaction whenever the market allows for it. It prevents you from having to manually leg in and out of positions which comes with huge amounts of execution risk.

The most significant of acquisitions has been both equity and debt of a USA entity that was the stinker that I had alluded to earlier. My timing appears to have been quite sharp in that the equity is actually up over 10% since I accumulated the position. I managed to get a fill on 80% of what I had seeked. On the debt side it has hardly budged, but it is trading at such a ridiculously good risk/reward situation that I had to nibble on both debt and equity. If all goes well (and this is always the big “if”), the income this will generate will be very pleasant to receive over the next few years plus a healthy capital gain if there is a payout at maturity. Time will tell.

I’ve acquired some long-dated out-of-the-money warrants (which are thinly traded but there is daily activity and a patient investor will be able to get fills in at the bid) of a reasonably-known firm. Performing a valuation of the overall entity (which has leverage issues but is still quite profitable and has been paying down debt considerably over the past couple years) suggests that given a moderate trajectory, the warrants should get at least at the money in the timeframe of expiration. There is considerable potential, considering past valuations, that the company will be significantly above that valuation so therefore the warrants present themselves as being cheap leverage. The common shares underlying the warrants are trading close to the 52-week lows. This story will take some time to resolve, but the results will become obvious much more sooner than the expiration date.

There are also provisions concerning change of control in the warrant indenture that would result in some form of payout if there was an acquisition bid under the strike price of the warrants. The company’s debt is trading above par.

The last acquisition has been of a company related to the economic crisis that Alberta will be facing. Their shares and debt have been hammered to death as a result of some exposure to capital spending in the oil fields. While my conviction is not huge (and this is represented by the relatively small stake I took), I purchased some debt relatively recently. Insiders have also been purchasing both equity and debt of this issuer and while financially speaking the company looks like it is going through a rough patch, they do have sufficient time to realign their operations where they can satisfy their bank creditors. Once again, time will tell.

Nothing that I have been acquiring is on any major index. I’ve been avoiding anything on an index that is tracked with lots of money for various reasons.

I’m also down to nearly a 25% cash position. The other component is that over half the portfolio is trading under tangible book value of the underlying companies.