Interest rates – watch out

The Bank of Canada yesterday had a more interesting than usual rate announcement:

The Bank is ending quantitative easing (QE) and moving into the reinvestment phase, during which it will purchase Government of Canada bonds solely to replace maturing bonds.

The headline is “ends quantitative easing”, but in reality, this is a reduction from $2 billion per week to $1.3 billion per week, which is enough to keep its $425 billion load of government treasury bonds level (the average duration of the Bank of Canada’s portfolio is 6.2 years, with most of it front-loaded in the first five years).

The picture painted (in the Monetary Policy Report) is projecting a restoration in the next couple years, but I believe such forecasts are going to prove misguided in that they are too optimistic. I do not want to provide much evidence to this claim here, however.

The Bank of Canada is trying to slow down the liquidity party without crashing the asset markets. This is going to be very interesting. In Canada, the big number to watch out for are the reserve levels of the banks that the BoC has bought the government debt from – this is the feedstock for the creation of currency, and there is still a lot left in there.

If history is true to form, things will appear to proceed until monetary conditions start choking and that’s when you’ll see the onset of further monetary policy induced volatility (which will then trigger another round of QE). We’re a bit of a ways from this point, however. The BAX futures are predicting quite a few interest rate hikes by the end of 2022.

A word of caution – any of your investments relying on this excess liquidity, be very careful.

Q4 IPO – typical SaaS issue

This analysis is not too deep, but I note that the IPO of Q4 Inc. (TSX: QFOR) had a tepid reception by the market – the IPO price was CAD$12 and the stock traded mildly under this after opening.

Q4’s primary function is to provide an investor relations portal for companies. It’s a distinct market and from what I can tell, the software does add value by offloading various functions that corporate secretaries would have to handle themselves (such as virtual AGM processing).

From the prospectus, we have:

As at June 30, 2021, approximately 50% of the companies that comprise the Standard and Poor’s 500 Index (“S&P 500”), 63% of the companies that comprise the Dow Jones Industrial Average (“DOW30”) and 48% of the companies that comprise the Russell 1000 Index (“Russell 1000”) are Q4 customers, and these numbers and their associated revenues continue to grow quickly

This is a reasonable sample – half of the Russell 1000 use this software.

Indeed, on June 30, 2021, there were 2,505 customers of this software. For the first half of the year, the average revenue per account was US$18k.

The IPO valuation is CAD$510 million on a fully diluted basis. The balance sheet is relatively clean, and they’re looking to raise CAD$100 million for the next ramp-up. The reason for this is despite them obtaining a credible variety of customers, they still have not been profitable.

This is a pretty good example in my books as a software-as-a-service that is scale limited and does not deserve a typical SaaS valuation.

There are two general issues here. Scale and competition.

On scale, how many publicly traded companies are there in North America?

The TSX and TSXV combined have about 3,300 listed companies. The NYSE has 2,300, Nasdaq about 3,700. Then the next tier, CSE is about 720, and OTCBB/Pink Sheets (which also covers international tiers and is quite redundant). I’m ignoring international (a logical audience would also be Australian and UK companies). Let’s ignore OTCBB and international for now and just focus on the first few – we have 10,000 listed companies as the target market.

They’ve already penetrated a quarter of this market. On a logistic curve, they are probably well past the half-way point on the y-axis in growth.

However, let’s say they manage to obtain 100% of their potential client base (a huge and unrealistic and wildly optimistic assumption). That’s a US$180 million revenue stream, a good chunk of money. But that’s the best case scenario short of offering parallel software packages to boost per-customer revenues.

The SG&A and marketing expenses of a software provider are not to be underestimated, let alone R&D expenses. They are material. One would think they will scale down, but it never quite ends up working that way.

Finally, there is competition – the cost of a company to switch to another provider. In the IR space, one would surmise it would be easier to transition than some other mission-critical software applications where discontinuity means death to a business. For US$18k/package, it is a trivial expense for many corporations. This works in favour of Q4, but as they try to raise the per-customer spend, it will most definitely attract competition of some type.

For these simple reasons, Q4 is a company I am not too interested in at this valuation. They have a good niche, but just because your company is in the SaaS domain does not mean you deserve Constellation Software valuations (currently 8 times sales). Good on Q4, however, for raising CAD$100 million. I think they hit the market at precisely the right time.

Arch Coal’s Q3-2021

ARCH is clearly a type of company where the analysts have most of the information well before the retail investor, which makes short-term trading of it a money-losing venture. You can see this in today’s trading action where pretty much most of the professionals got it right.

There is value, however, in making medium-range outcomes, where the playing field is a lot more level.

This is where it gets interesting today, specifically the question of how long this party in coal will last.

Putting a long story short, the demand for steel has increased since 2020’s Covid hit, while global supply of metallurgical coal has decreased. This is causing the current situation where steelmakers are forced to pay up.

Upon review of ARCH’s Q3-2021 conference call today, we have a company that is working like mad to sell both met and thermal coal. Indeed, they have pre-sold most of their 2022 thermal production at Powder River Basin at a margin that will likely net them about $10/share alone. On the met coal side, they are looking at spot seaborne prices of US$390/ton, and they have already been making sales for next year domestically in the US$200s, plus the added 3 million tonnes that gets produced in the Leer South project.

The majority of 2022 looks locked and loaded and will be incredibly profitable. It’s going to be, conservatively, about $600 million in free cash, probably more. Most of the capital expenditures will taper in 2022 as the last major construction project (Leer South) is done, and will clock around $125-150 million for the entity.

Mentally, this 2022 incoming cash flow can already be subtracted from the valuation as this is a known quantity. Factoring in Q4-2021, you can subtract about $50 of so off the stock price for the rest of 2022. The number might be even more, depending on how much high-priced met sales they can get off.

The question and value that an investor can bring to this point is what the heck is going to happen in 2023 and beyond (they’re already trying to sell 2023 production).

Right now, the stock is trading at a Price/2022 FCF of a low single digit multiple, perhaps around 2 and a half. Your valuation exercise, and what the sharps with the real information do not have, is what economic conditions are going to exist a year from now?

If things continue as-is, ARCH continues to be a dramatically undervalued stock – for each and every year these conditions are expected to continue, you can pack on another $50 or so to the stock price beyond what you currently see.

If you expect a crash in coal pricing (e.g. other international jurisdictions get their act together to ramp up supply, or steelmaking crashes), then you’ll take a hit. Depending on how bad it is, you could see a quarter of your investment evaporate.

Your typical spreadsheet analyst probably loves technology companies because their revenue curves fit really well to models. Earnings are predictable, and everybody is happy. However, the real value in investing is made in very jagged situations like this one.

Management is taking a very cautious approach with capital allocation. Their first priority is to pay down as much debt as possible (which they will be able to do in 2022) and then pre-pay some asset retirement obligations with the thermal business. They should be able to do both in the first half of 2022. They instituted a nominal dividend (25 cents/share/quarter) which will get some income ETFs in the mix, and then sometime in 2022, if the stock is still at their current levels and the commodity is still at highly profitable levels, will probably institute a buyback, although at a lesser scale than the overkill they engaged in 2019. I would expect the dividend to also increase in 2022.

Considering that costs on their met coal side is around US$60/ton and the commodity price is well into the triple digits, there would have to be a considerable crash before that business reverts back into a breakeven mode. It’s a pretty big cushion, albeit the coal market at this moment must feel like the conditions that traders of GME were facing at the end of January this year.

I think once the coal tourists get shaken off with the existing volatility and relative price disappointment (“Why isn’t this thing trading higher than 2 times earnings???”), the stock heads higher. The tough part, however, will be the day where you sell it at 4 times. Not today.

What do you do if you’re a steelmaker?

Steel factories at this moment must be facing a huge dilemma.

When your industrial process involves millions of tons of materials, you can’t exactly click a button on Amazon to get your feedstock – you need to order your inputs months in advance, if not years through a long-term supply contract.

So when prices are sky-high for metallurgical coal as they are, do you continue waiting and increase the risk that you will get no supply, or do you bite the bullet and secure a contract today?

At high prices, you are very unlikely to procure a long-term contract (who wants to lock in record-high prices on the buy side?). But you run the risk of not being able to properly price out your raw product to your own customers. It is a terrible situation.

We have a Q1-2022 pricing article that has the following:

US coal mining firm Arch Resources is offering a January-loading Panamax cargo of Leer high-volatile A coal at $410/t fob US east coast, with expectations of securing at least $400/t fob. The Leer high-volatile A coal continues to command a premium in the market, being particularly well-established in the Chinese market. “We are having trading firms chasing us pretty hard for high-volatile A coal into China,” said another US mining firm that said a European buyer was seeking 30,000t of high-volatile A coal last week. “We would be pushing for above $400/t fob ourselves.”

(fob US east coast, for those unfamiliar with shipping, means that once the coal is loaded on the east coast ship, the buyer pays and it is the buyer’s risk in the event of any catastrophe).

US$400/ton is a lot of profit, especially on a company with a US$50-60/ton cost structure. How long will this party last? Will any producers be able to supply long-term contracts at these prices, or will demand for steel plummet?

The booming fossil fuel industry

Over the next few weeks, oil and gas companies will be reporting their third quarters and give projections based off of the existing strip pricing.

For gas producers, winter gas prices appear to be headed to around CAD$5/GJ (AECO pricing), while if you can get the stuff onto a tanker and ship it to Japan or Korea, it’s going for about US$35/mmBtu (one million BTUs is about 1.06 GJ).

The spot oil price has also gone up about US$10 since the last slew of quarterly reports.

The first shot that was fired was on October 14 when Whitecap Energy (TSX: WCP) announced its 2022 capital plans and projections. In addition to ramping up production mildly (from 111k boe/d to 122), at a US$70 WTI price (note that spot crude is US$83 as I write this), they anticipate generating $911 million in free cash flow, and this is after capital expenditures and accounting for some idiotic hedges that will result in some considerable losses.

Let’s focus on the $911 million in free cash flow. At the end of Q2-2021, WCP had $1.3 billion in outstanding debt, and a market cap of $4.8 billion. This works out to a 15% return.

Others in the Canadian energy complex have similar metrics.

De-leveraging has been the focus of all of the companies – I suspect they are getting concerned that the banks and financial institutions are going to be pressured to “defund” or put pressures on their credit lines (a “climate surcharge”, etc.). Debt financing can be focused on bond issuances rather than relying on lines of credit.

In the case of Whitecap, as their dividend payout rate is very low, if they keep on their existing track they will be able to eliminate most, if not all, of their line of credit by the end of 2022. Out of the $1.3 billion in debt they have at June 30, 2021, $740 million is bank debt and $595 million are in senior secure notes – $200 million maturing in January 2022, May 2024 and December 2026.

The even rosier news for the industry is the lack of material capital investment in the sector. This gives huge incumbency advantages for the existing players. Traditionally at this phase of the boom-and-bust cycle, you would hear companies pouring billions of dollars in extra capital spending, but companies today are being very cautious. While market valuations would suggest that this pricing level is temporary, I would bet against that. Although prices will never move in straight lines in the short term, the overall trend is quite positive.