Search for yield – Dundee Corp

Dundee (TSX: DC.A) is an investment corporation. They are family-controlled (by the Goodman family) who control approximately 87% of the voting interest and 18% of the economic interest of the firm through a typical dual class share structure.

By virtue of owning Dundee Financial and other majority and minority-held investments, their consolidated financial statements are a mess to read. When pulling apart the components, they are diversified among real estate, energy, financial, mining and agriculture, in that order.

At the end of the day their stated book value is about $1.45 billion dollars, trading at a market capitalization of about $540 million. There are good reasons to believe the book value will be impaired simply due to their slowness in writing down some investments that clearly will not perform, but even assuming a 50% write-down (which seems appropriate) this brings the entity down to a liquidation value that is still well above its market capitalization.

On the liability side, the holding company has $92 million in term facility debt and subsidiaries make up approximately $100 million more in non-recourse debt. The leverage is not huge. The term facility is good for $250 million total and expires in November 2016 which is salient to the discussion below.

I generally have an aversion to controlled corporate structures as a minority holder unless if there are significant reasons why one would believe there is an alignment of interests. There also needs to be some reasonable assurances there isn’t a cesspool of conflict of interests in the other subsidiaries / operating companies that would cause shareholders to believe they are being taken to the cleaners with. I don’t get this element of confidence with Dundee, so I would steer away from the common shares. This is also found in companies with similar capital holding companies, including firms that have been on and off my radar (let’s be specific: Pinetree Capital is one of them – trading at around 50% of reported net asset value!).

On a more humorous note, Dundee’s logo also looks like the Blackberry logo, which is kind of disturbing considering how Blackberry has fared:

At least their logo is pointing upwards instead of flat.

I am writing not about the common shares, but rather the preferred share securities of Dundee. They have a series of preferred shares (Series 4) which has a par value of $17.84/share. The reason for the unusual par value was because Dundee split off DREAM Unlimited (TSX: DRM) which partitioned the original preferred share series issue (into DC.PR.C and DRM.PR.A). The shares have a coupon of 5%, paid out quarterly.

The preferred share series has an interesting feature: they are redeemable by the holder for $17.84/share after June 30, 2016. They are also retractable by the company indefinitely (at $17.84/share cash) and convertible into common shares at 95% of TSX market pricing or $2/share, whichever is more until June 30, 2016. The aggregate value of the preferred shares at par is $107 million.

This creates a rather interesting situation where an investor can purchase shares today (trading at roughly 97 cents on the dollar) and force a redemption in about 10.5 months’ time, skimming a 5.15% preferred yield and a 3% capital gain. One clear risk is whether the common shares will be trading above $2/share by June 30, 2016, which would seem to be a likely bet even if the underlying asset value of Dundee’s oil and gas companies are seriously impaired. It also does not help that most of their operating entities and equity-accounted entities are losing money, but the question is how much money will they actually end up losing between now and June 30?

There is also sufficient management interest in ensuring that their (not trivial) 18% economic stake in the firm is not diluted with a share conversion, coupled the with the fact that their operating credit line appears sufficient to pick up the bill (in addition to the $87 million cash they already have on hand in the holding corporation).

The preferred shares are extremely illiquid and trade in a narrow range that is presumably due to the redemption/retraction feature.

It is an interesting gamble that seems like it is reaching out for yield, but with an element of security given the pre-existing credit facility and 80% distance between the existing common share price and the $2 floor for preferred conversion.

In relation to the tax-preferred status of an eligible dividend coupled with a (presumed) capital gain at the end, one is looking at a functional tax-preferred 8% with a reasonable amount of asset security (although the security is implied by redeem-ability, definitely not direct security!), contrasted with a fully-taxable 1-year GIC at 1.2% (without liquidity) or 0.85% with liquidity. The spread seems to be a reasonable compensation for risk.

I would like to thank a comment poster by the name of Safety, who on May 25, 2015 posted about this in one of my prior rantings. I was indeed quite surprised at the quality of this person’s comments and hope he can chime in here again.

Anyhow, I finally picked up a few shares.

Purchased Bombardier Preferred Shares – Investment Analysis

Bombardier (TSX: BBD.B) has been on my radar screen since the beginning of the year when the pulled off a secondary offering that was force-fed to the public.

Over the past week I have bought Bombardier’s preferred shares. Specifically I have bought the preferred shares BBD.PR.B and BBD.PR.C, which have somewhat different characteristics.

BBD.PR.B gives out a dividend that is adjusted according to the prime rate given by the various big banks. Right now prime is 2.7% on a $25 par value, so that works out to 67.5 cents per share, paid out in monthly installments. At today’s market value it is trading at a yield of 11.1%. The shares can be converted to BBD.PR.D in August 2017 at a rate that is to be previously declared by management that is a function of the 5-year Government of Canada bond yield. In August 2012 it was 220% of the 5-year bond yield. Generally speaking with bond yields as they are at present I would not expect too much of a fixed premium to be assigned to the conversion.

BBD.PR.C gives out a 6.25% dividend on a par value of $25, so $1.5625/share paid in quarterly installments. At today’s closing price that works out to a 13.1% yield. This series of preferred share can be converted by the company into BBD.B equity at 95% of the closing price of the shares over a pre-determined time span or $2/share, whichever is more.

Both series of preferred shares are cumulative.

So why buy into something so obviously risky? The short story is that this appears to be a high risk / very high reward situation. There are a few reasons to believe that the risk is higher than what the market is perceiving.

On a technical basis, it is clearly obvious that investors have given up on the company. Anybody sitting on the preferred shares since the beginning of the year has lost about half their equity and the same can be said for the common shares. While this is a relatively unscientific comment, sentiment as seen through the stock graph is horrible. The sentiment could get even worse (i.e. go to zero) but despite what most retail financial literature specifies, portfolio returns are highly magnified if you can avoid catastrophic time periods and likely most of Bombardier’s catastrophic period is in the past. Price and volume suggest panic and it is best to invest in a panic situation.

I can’t see people within various pension funds and institutional investors credibly recommending to their investment committees the purchase of Bombardier at this time. The risk has simply gone too high. As a result, the shares (both common and preferred) have cratered. The question at this point is assessing whether sentiment can get worse (resulting in lower prices) or has bottomed.

Operationally and in terms of sentiment, the mass media has focused on the consistent delays on the C-series airplane that is designed to compete against others in the 100-149 person segment. The development of this aircraft continues to cost the company considerable amounts of cash – debt has risen to $9 billion at the end of March 2015 compared to $5.4 billion at the beginning of 2013.

In fairness, the cash balance between those two time periods has also gone up, from $2.6 billion in January 2013 to $4.7 billion in March 2015. The net debt position would be $4.3 billion which is not terrible.

In the last raising of capital, the company forced through a bond offering that functionally extended their nearest term maturity out to 2018. They managed to get a 5.5% coupon on 3.5 year money and 7.5% on 10 year money.

Investors that bought into the 10 year bond would doubtlessly be pleased to know that what they had bought at par is now 83 cents on the dollar (or approximately 11% yield to maturity). The 3.5 year maturity issue last traded at 94.7 cents (or 7.6% YTM).

Their yield curve would still suggest they are not going to be shut out of debt financing.

bbdyieldcurve

So they have a couple years to figure things out. Considering they have seemingly gone through a whole host of management changes in the first half of the year, presumably there will be a renewed focus to solve the issues the company is facing. I also do not know of any aircraft projects that were ever delivered on time and budget.

The company has a profitable transportation division which they are planning on bringing public. This would also give the underlying entity a bit more market value than what is being prescribed (a 3.8 billion market cap plus $4.3 billion net debt position gives an enterprise value of approximately $8.1 billion). For a company doing $20 billion a year in revenues, one would pause to think if a more rational valuation were prescribed to the firm on the basis of revenues.

It is likely any recovery in the company would clearly result in equity appreciation for the company, but also as the credit profile improves, preferred shareholders (especially the BBD.PR.B series) would see considerable capital appreciation, nearly in line with the common shares, with the added bonus of the income payments on the side.

If interest rates rise, BBD.PR.B investors would receive a small bonus. I’m not holding on my breath for an increase in interest rates, however. However, I do believe that 0.5% is the lowest the Bank of Canada will go.

There are obvious risks. The chief risk is the company will suspend dividends and the shares would most likely drop to half of what they are trading at presently. The company suspended dividends on common shares earlier this year and may decide to drop preferred share dividends as they constitute a cash drain of CAD$23 million/year that they would want to otherwise save. They can also save half of this by converting the BBD.PR.C series into equity, a decision that I doubt they would make (they would rather suspend the dividend instead).

There are two good reasons why they won’t: they would likely compromise their ability to access the bond market, and the controlling family (that owns a majority of the votes in the corporation) would lose one more element of the privilege of controlling who is on the board of directors: declaring common share dividends. It does not seem likely at this time that they will suspend dividends unless if things get worse than present. There are other issues concerning the control issue that I will not write about in this post.

There are other positive and negative catalysts, most of which are not being priced into the market. I won’t go into those.

I have omitted a lot of the analysis (including the relationship between the various world governments and Bombardier), but I have written several elements to consider. While I am not too interested in the common shares, the preferred shares do give me interest, thus my purchase. This is not for the faint of heart – this is a high risk investment. If a stabilization comes to fruition and Bombardier manages to plod along, the preferred shareholders are good and will be earning significant income for the indefinite future.

Sleep Country Canada goes public – brief analysis of IPO

Sleep Country Canada (with the cutest ticker symbol on the TSX, ZZZ) goes public after they were taken private half a decade ago. The hedge fund that took them over is still up on a market capitalization basis, but they still have to liquidate approximately 47% of their holdings in the post-IPO organization. The hedge fund also lent the operating entity money which they received a slick 12% for (this is being converted into equity again and replaced with a more conventional credit facility post-IPO).

ZZZ raised a ton of money in the equity offering but it went to facilitate the internal takeover of the operating subsidiary and a partial buy-out of the hedge fund. There is also some equity remaining to pay off some debt of the operating entity so the business in general doesn’t look like a leveraged train wreck.

The underlying business within the holding company is of average financial profitability considering its retail business – very roughly speaking over 2012 to 2014 it has cleared a 9% profit margin before interest and taxes.

When doing the analysis, however, my question was not whether this company should be going public or whether it should be purchased, but rather: how the heck did they manage to get people to pay $17/share for this? On almost every valuation metric I can think of, I would not be interested in looking at this company until it reaches about $10/share (this is roughly 20% under a fair value estimate of $12.50/share). There are a lot of strikes against ZZZ at $17/share:

1. Its retail niche is not a growth market (despite what is claimed in the prospectus), especially considering its top-dog status in the Canadian market – thus not warranting any sort of real “growth valuation”.
2. The profitability of the market is not extreme (although one can make an argument that it will be more difficult to erode from the Amazons and big-box retailers compared to the retailing of trinkets) and one is very hard-pressed to find why existing margins will rise beyond economies of scale;
3. Investors should continue to pay a discount, not a premium, due to the fact that they are (nearly) minority investors in relation to the 46% owner (Birch Hill) sitting in the room looking for an exit;
4. Tangible book value after offering is going to be negative ~$142 million – this is purely a cash-flow entity one is investing in. If they were a growth company, why would they give out a planned 11 cents/share/quarter dividend?
5. I don’t ever invest in companies that have their ticker symbols not represent an abbreviation of their company name. Seriously.

At $17/share ($640 million market cap), I don’t have a clue why people would want to invest in this. Who should be congratulated are the insiders and the financial institutions that actually managed to find purchasers of this stock – well done!

Canadian interest rates

The Bank of Canada dropped their target interest rate from 0.75% to 0.5% today.

Canadian currency has taken a plunge in response. In addition the Federal Reserve Chair has pledged to start “normalizing” US interest rates by the end of this year which also puts downward pressure on all non-US currencies.

cdw

While I rarely have strong feelings on currencies, the “perfect storm” for the Canadian dollar is brewing (lowering interest rates, lowering GDP, lowering commodity prices, lowering external trade with China/USA, political uncertainty over the October 19 election) and it appears more likely than not that we’ll start approaching the point where we’ll see some sort of floor on Canadian currency (simply because the news could not get worse). I’m going to guess it will be around 72-74 cents, but we will see. I’d also expect this low to be reached around October and I may make a significant policy change on my CAD-USD holdings at this time given valuation levels.

My working theory is that the US economy is going to have extreme difficulties adjusting outside of a zero-rate environment and the process of deleveraging will be a painful business when hedge funds can no longer obtain money for free (Interactive Brokers, for example, will happily lend you USD at 0.63% for more than a million and 0.5% for more than $3 million). Paradoxically if the 30-year treasury bond decides to spike up from 3.2% to around 3.5% yield levels, I would suspect that purchasing long-term treasuries are going to be the winning play over the next period of time – not any equity fund. Debt levels incurred by the US government are hideously high and with every quarter point increase that they face will be a disproportionate amount of interest expense going out the door.

This also does not factor in other entitlement spending (e.g. social security, medicare, etc.) that serves to effectively ramp up the net expenditures for public debt purposes.

Right now I am mostly cash (or near-cash). Some of my efforts to find a place to park cash have mysteriously yielded results that are relatively low risk and I’ll be able to realize a modest single digit percentage at the cost of a little bit of liquidity, but in the event there are better investment opportunities on the horizon I will be in a very good position to pounce.

Canadian Housing Financing Market

There are three companies that come to mind that are directly related to Canadian residential housing financing: Genworth MI (TSX: MIC), Home Capital Group (TSX: HCG), and Equitable Group (TSX: EQB).

I’ve done extensive research on all of them in the past and I am research-current with all three companies. I do own shares of MIC from the summer of 2012.

The first, which should be no surprise to regular readers here, deals with mortgage insurance. The second and third deal with direct financing of home mortgages (both first-line and refinancing). If a mortgage is required to be insured (which is usually the case for higher ratio mortgages and refinancings) then CMHC and Genworth MI get involved and charge a premium in exchange for the lender being able to give out a lower rate of interest.

HCG today announced that its mortgage originations were down from the previous year and its stock price cratered roughly 15% as of the time of this writing.

Genworth MI is down about 4% in sympathy, although Equitable Group is in the “white noise” range for the markets (i.e. relatively unchanged).

A downturn in mortgage originations will materially affect HCG and EQB’s profitability, while this has more of a muted effect on Genworth MI as cash proceeds from mortgage insurance are not accounted for as revenues until they are recognized according to prior experience (net of expected default losses).

The takeaway to this message is that if Genworth MI gets disproportionately trashed in the upcoming days, it is likely unwarranted as the fundamental profitability in Genworth MI is not through volume, but rather the solvency of the lenders in question. Genworth MI also has the advantage of being able to run off its insurance book and still receive a boost in market value as it is trading below book value, while HCG and EQB are trading above book value.

Option implied volatility does suggest that institutional interest suspects further volatility. Tread carefully as always!