Canada – Page 12

CoronaPanic, Edition 10

Random observations:

Barring any more catastrophic news (e.g. China launching a military invasion), Vix has likely peaked:

There might be another spike up but I’d suspect that this will subside over the coming months as the fallout is now being quantified and known.

I have done some radical portfolio re-alignment over the past couple weeks. I’ve not been thrilled about my performance, which I’d consider to be mediocre at best. The choice to diversify was correct. An acknowledgement of my own stupidity is in the form of index longs on the S&P 500, which is just trying to get a broad-brushed swash of what is going to be a gigantic capital influx because the “borrow at 1%, long at 10%” trade is going to turn that 10% into 8%, 6%, and 4% before we experience the next leveraged crash.

Speaking of what’s above 10% yield, have you looked at anything relating to the debt markets lately? Print up a list, get a dartboard, and throw darts at it, and you’re likely to do good.

Same thing goes for most of the preferred share market, although you have to wonder about the state of those 5-year resets. Still, even if you assume the 5-year GOC bond yield stabilizes at around 50bps, you can buy some reasonably safe income streams. The only problem is when the market rockets up, you’re not going to be able to benefit as much.

Q1 and Q2 results are going to be horribly impacted, and this is going to make the P/E and PEG metric useless as an investment tool going forward for the next 18 months.

There is still going to be a whole bunch of ups and downs at wild magnitude. Resist the urge to buy on a +8/10% up day like today, and resist the urge to sell when we inevitably get a -5% day and you should do well.

Envision what’s going to still sell a year out. Businesses that were looking shaky before this crisis are likely to go belly-up, and even in a recovery will not recover to the extent that others will.

The math of portfolio management is that if you take a bunch of positions at 5% (or any arbitrary number), some will gravitate up, and some will gravitate down. The ones gravitating up are ones that you happened to pick at a reasonable time (or hopefully the choices themselves were skillful) and thus they will have a larger weighting. Thus future changes in these larger weighted items will have a more disproportionate impact on the overall portfolio, while those that slide down will have less of an impact. It’s exactly how capitalization-weighted investing works with indicies – the strong get stronger, while the weak get less capital. And if you pick something that goes up by a factor of 10, you can still have 9 total wipeouts and break even.

Finally, there is going to be an element of luck and iron steel nerves to pick at the entrails of those that get totally crushed by this – cruise lines, airlines, oil production, and anything very retail-driven. If you pick equity survivors out of those (especially those that are regarded as already written off to go into CCAA/Chapter 11), you will receive huge multiples on your investment – but these come at extreme risk of a permanent loss of capital. Ultra-high risk, ultra-high reward.

Companies buying back stock during the CoronaPanic

So far this week, the following TSX companies have reported buybacks (at prices where companies actually add value by doing this!):

5N Plus (TSX: VNP)
Cascades Inc (TSX: CAS) – Note: they sell TISSUES and TOILET PAPER and you’d never guess we are in the apocalypse by looking at their chart
CIBT Education Group (TSX: MBA)
First Majestic Silver (TSX: FR)
Goeasy (TSX: GSY) – wow, they’ve gone off a cliff
Granite REIT (TSX: GRT.UN)
High Liner Foods (TSX: HLF)
Melcor Developments (TSX: MRD)
Melcor REIT (TSX: MR.UN)
Mullen Group (TSX: MTL)
Osisko Mining (TSX: OSK)
Rogers Sugar (TSX: RSI) – trading at a 5-year low. Company is still slightly debt-heavy IMO, but buybacks at this price does make sense

I also have read Atlantic Power’s (TSX: ATP) press release where it is pretty obvious they have been purchasing common shares and preferred shares in March, quite above their normal rate.

Dividend cuts

Those cash-flowing equities with yields are going to cut dividends simply because there’s no other outlet. If you’re depending on a stock for their yield, one must have a good grip on whether they can sustain it from a balance sheet perspective.

I won’t even cover the oil and gas sector – those that had dividends will surely lower or eliminate them (SU and CNQ may be exceptions here, but everybody else – good luck!). In Canada, nobody will make money with WCS at US$20/barrel. Interestingly enough, in the gas world, AECO/Dawn/Henry Hub are holding steady.

Chemtrade Logistics (TSX: CHE.UN) announced they are dropping their distribution from $1.20 to $0.60/unit per year. This wasn’t surprising to me since even at the current rate they are still questionable.

Melcor (TSX: MRD) decreased their quarterly payment from $0.12 to $0.10/share; as their property portfolio is entirely Alberta-centric they are secondary roadkill in the oil/gas slaughter.

Anything in the equity markets that are trading at double-digit yields – give the balance sheets a very careful look, and ask whether the cash flow, accounting for a decrease in the economic landscape, will be able to provide sufficient coverage.

There will be a few equities with double digit yields that will recover and maintain their dividends, but it will be few and far between. However, if you do manage to snag them, and the overall economy recovers, you will be the recipient of a yield compression and continue receiving distributions at your original (low) cost basis. High risk, high reward.

Canadian Preferred shares are getting killed

The rest of the stock market is getting killed by the Coronavirus as well, but Canadian preferred shares are not much of an escape valve.

James Hymas reported today that:

It is noteworthy that the Total Return version of TXPR closed at 1,304.43 today. I will note that the value of this index on September 30, 2010 was 1320.92, so total return has been negative over the past NINE YEARS AND FIVE MONTHS and a little bit. That’s before fees and expenses. Remember those charts I published in the post MAPF Performance : August 2019 illustrating the downturn to date, comparing it to the Credit Crunch and remarking that there had been zero total return for seven years and four months? Well, those charts are now out of date.

The two major ETFs which trade in Canadian preferred shares are ZPR and CPD, and they both have been murdered in the past two weeks, roughly 17%:

A negative total return of 9 years and 5 months can be contrasted against the TSX total return of about +4.5% (compounded annually) in the same period. In theory, preferred shares are safer investment vehicles than common shares, but clearly as the 5-year rate reset preferred share came to dominate the market, as 5-year interest rates have declined, they have also taken down the capital return of the preferred shares, resulting in very lacklustre long term performance.

This can only be considered to be a total washout that is going on.

One reason is perhaps that leveraged players are being forced to cash out. A retail example is in this reddit post, where the poster very thoughtfully constructed a diversified portfolio of preferred shares, and who is certainly underwater on this trade.

The math was pretty simple: Choose a “stable” preferred share (e.g. BAM.PR.Z) (4.7% and a rate reset of 5yr+2.96%, which presumably would be ‘stable’ since obviously the five year government bond will hover near 1.7% and you won’t get ripped off on the rate reset!). You borrow money at 3.3% from a proper brokerage firm, and leverage $100k of equity to buy $200k of stock, and voila. At the beginning of 2020, the shares would yield 5.9%, and your net would be 2.6%, minting a cool tax-preferred $2,600 in the process per $100k equity.

The problem is today, those BAM.PR.Z shares are worth $160,000, your net equity is down to $59,175 (had to pay the interest expense) and the only thing you will be receiving in this procedure is a first dividend payment of $2,928 tomorrow (which will correspond with a drop in the price of the preferred shares, so this is a push). Your margin level has gone from 50% to 37%, and this is precariously close to the 30% level which is allowed by the IIROC list of securities eligible for reduced margin and the brokerage firm.

Surely these preferred shares couldn’t go down further, to the point where you’re going to be forced to clear out your account? Can you take the risk being so close to the brink of a margin call?

This is part of what is going on. The other aspect is that the market is pricing in the reduced dividend rate that will inevitably occur with the rate reset. At a 5 year government of Canada bond rate of 0.55%, that BAM.PR.Z yield, after the reset, will go from 5.9% to 4.4% on original cost, which cuts heavily into the original intention of the trade, which was to skim a leveraged return off the dividend. The only solace is that the short term interest rate (that you would pay for margin) also decreases, but then your capital is impaired – you can realize the capital loss today, or wait patiently and hope for better times and hope things don’t get worse to where you will face that margin call.

These two factors I suspect are driving the push down in preferred shares. What will be even more fascinating is if we enter into a negative yield environment – preferred shares will look even uglier then.

Even the preferred shares with minimum rate guarantees (e.g. TRP.PR.J – 5.5%, reset at 4.69% with a minimum of 550bps) have not been immune to selling – although you are guaranteed a 5.5% coupon payment (and traded at a 4% premium to par for this minimum rate privilege to yield 5.3%), this series has been sold down in the past few weeks to 91.5 cents of par, or a minimum yield of 6.01%. Fascinating times.

Fortunately a couple weeks ago I sold all of my preferred shares short of a 2% position in something which I’m still not happy at myself for not unloading when I saw the proper bid for it.

Finally, the only solace for the rate reset preferred shares that are resetting at the end of March is that five years ago, the five-year government bond rate was 0.93%. I bet the people receiving that rate never thought they’d be getting a lower rate at the end of this month.

Canadian Newspaper Publishers – Torstar, Postmedia and others

Even though one would think with the S&P 500 and TSX being at heights that I would find the markets devoid of investment opportunity. While the Amazons and Facebooks of the investment world do appear to be expensive (and entirely propelled by deficit spending, federal reserve meddling, low interest rates and a good dose of TINA), the smallcap world, much to my surprise, has been full of plenty of research candidates, both old and new. I’ve been doing due diligence on various companies over the past couple months and have nibbled here and there. Nothing was as obvious as Yellow Media was in the 6’s in early 2019, but several items have received my interest and present reasonable risk/reward ratios.

I will write and disclose one of them simply because I have gotten my position (it is a very low percentage position in the portfolio, as in my minimum size to warrant opening anything) and I am not interested in accumulating more at lower prices. I will also caution that its liquidity is less than stellar.

I will piggyback on the post Tyler did with FP Newspapers (TSXV: FP) – well worth the read – he did a good job. Just be warned if you trade FP that you can move the stock price 20% with a few thousand dollars of volume!

It is well known that the traditional news publishing industry has been upended by the internet. Even Warren Buffet was caught flat-footed by this to some degree (he has made multiple comments on two-decade ago annual reports about the competitive position of single-community newspapers). However, I will make the claim that most of the damage in the industry is done. It is not completely over but the horizon is finally visible again.

In terms of publicly traded companies in Canada (on the TSX), we have the following:

* Torstar (TSX: TS.B) – notably owning the Toronto Star, Canada’s largest daily newspaper. Will write about them in more detail below.

* Postmedia (TSX: PNC.A / PNC.B) – National Post, and many prominent regional media, including the Vancouver Sun, Calgary Herald, Toronto Sun and Montreal Gazette. The stock, despite having over 90 million shares outstanding and a $120 million market cap, is very illiquid. They have an anchor around their neck in the form of nearly $250 million in debt and mandatory cash sweeps, contrasted with the trickle of operating cash flow they do generate.

* Glacier Media (TSX: GVC) – Owner of some 60+ local news media brands, although this is a subset of their other significant business offerings. Unlike Postmedia, the stock usually trades in a day, and the bid-ask spread is much more reasonable (pennies vs. dimes). Their Community Media category (which includes publications such as the Victoria Times Colonist) is approximately 60% of their revenues. They have been treading water financially, and have a very modest amount of debt on their balance sheet (about $20 million). They are, practically speaking, controlled by the entity that controls Madison Pacific (TSX: MPC.C).

* Québecor (TSX: QBC.A / QBC.B), which also owns the major French language publication (Le Journal de Montréal) and others in French language. Québecor is well diversified beyond its ownership of newspaper publications (its ownership of Videotron, for example) and really doesn’t fall into the “trading like trash” category of the three companies listed above.

I’m only going to look at Torstar in this post. This post has less quantitative rigour than my usual posts but I’ve done those evaluations off-line. Also, I’ve been less than comprehensive in writing the following analysis, but there have been plenty of other considerations taken into the scope of this.

Structure

The company has a dual class share structure. Its original founder and owner, Joseph Atkinson, who died in 1948, left behind the company to his successors who own the Class A voting shares.

The Class A shares (approximately 9.8 million outstanding) have voting rights, are not publicly traded and are owned primarily by a voting trust that joins together seven groups of shareholders. These seven groups (descendants of Atkinson) collectively hold approximately 99% of the Class A shares of Torstar and approximately 17% of the Class B non-voting shares of Torstar. They effectively control the nomination of the board. Class A shares can be converted into Class B shares. Class A shares cannot be sold in a take-over bid unless if the same offer is given to Class B holders.

The Class B shares (approximately 71.3 million outstanding) are freely traded, and notably Fairfax owns 28,876,337 shares or 40% of the class. Their last disclosed purchase was on November 9, 2017 when they purchased 9.4 million shares at CAD$1.25/share.

This dual class structure looks fairly typical, except for the following provision:

The holders of the Class B non-voting shares are generally not entitled to vote at any meeting of the shareholders of the Corporation; provided that, if at any time the Corporation has failed to pay the full quarterly preferential dividend on the Class B non-voting shares in each of eight consecutive quarters, then and until the Corporation has paid full quarterly preferential dividends (7.5 cents per annum) on the Class B non-voting shares for eight consecutive quarters, the holders of the Class B non-voting shares are entitled to vote at all meetings of the shareholders at which directors are to be elected on the basis of one vote for each Class B non-voting share held.

This creates a control incentive – the company must pay 15 cents per share in two year periods, otherwise Class B shares will get to vote for board directors (i.e. Prem Watsa will be able to obtain significant influence, if not control of the firm – his voting stake in this instance would be 36%).

The bulk of my shares were bought at 40 cents, which means if the Torstar board wishes to keep control, they have to pay a minimum 18.8% dividend at this cost.

On their Q3-2019 report, Torstar eliminated their dividends (it was 10 cents per year prior). You can see on the chart when this announcement occurred.

The board of directors stated they will review the dividend policy again in a year. I do not believe they will reinstate a dividend until there is obvious evidence of free cash flow, or Q3-2021, whichever comes first.

Financials

The following is a very broad summary. I’ve dived into the financial statements, but will pick on certain details. Print advertising is eroding at a very fast pace (roughly 23% from Q3-2018 to Q3-2019), and flyer delivery (which used to be a vector for advertisers to stuff more paper garbage into doors of homes that competed primarily with Canada Post’s unaddressed admail) is down 10%. Digital advertising and subscriptions are roughly level.

I do not expect there to be much recovery in print, but because revenues have already fallen so much, one can envision that the inflection point on the inverse “S” curve has been reached and that future revenue erosion will be slowing. Print advertising is still 30% of the total revenues. All of the advertising money has to go somewhere, and it is likely it will show up in the form of digital advertising (either on Torstar or thrown to social media), or “advertorials” and the like.

With revenue losses, cost containment becomes a much more challenging factor, and management has been trying to trim costs. For the most part their effort has not been sufficient in line with the drops in revenues, and there have been recurrences of “one-time” restructuring costs and so forth (the most recent going to be the shutdown of the StarMetro line of publications).

The other big component is the partially consolidated 56% ownership of Verticalscope, which is generating losses and the subsidiary has a $144 million debt which it is slowly chipping away at. Torstar has been less than transparent in terms of accounting for this investment, probably because it has performed so terribly. They were forced by the Ontario Securities Commission to change the manner in how they reported VerticalScope results. For the gory details, you can read Note 8 of the financial statements and the beginning of the MD&A document.

The consolidated balance sheet itself, however, is not in bad shape. The company has $52 million in cash, $9 million in restricted cash held generously in allocation toward an executive retirement liability, and no debt (the VerticalScope debt is non-recourse). There are significant liabilities on the books in the form of the employee pension plan, which is estimated to have a $127 million solvency deficit as of September 30, 2019.

This number might be a little scary, but it is not as if the pension plan is devoid of assets – at the end of 2018, there was $806 million in pension assets. There were $77.6 million in benefits paid that year.

The main point is that the company has some financial maneuvering room and time to work with. While the situation is clearly adverse, it is not at the point where it encumbers management’s ability to operate (unlike Postmedia, where the high interest rate debt is like an anchor around the neck of the whole company).

Intangibles

The large intangible aspect that makes Torstar alluring is name recognition – being a major media driver in itself, with obvious critical mass, provides value. There are analogs to this, the most relevant one being the decision that Jeff Bezos made when deciding to purchase the Washington Post in 2013.

The other intangible aspect is that the Toronto Star is obviously aligned with the federal partisan leanings of the existing government, which means it will continue to be a receptive economic vessel for the federal government. The journalism tax credit is one instance of this.

Competition

Direct competition – The Globe and Mail (owned by another historical family-owned media empire, Woodbridge Company) is the only other direct competitor in this space. They are effectively the two legacy national (English language – Québecor owns the French one) newspaper organizations.

Other than this, the other competition is through other domains – broadcasting news, internet, and independent publishers. The combination of these three has lead to a non-trivial erosion of the fundamental business, but this has been well explored elsewhere.

Sentiment

Bad. Really bad. Other than the negative dynamics of the newspaper industry, the suspension of the dividend was probably the last nail in the coffin for a lot of investors to finally bail out. I do suspect a lot of the trading since that announcement was fueled by tax loss selling. Q4-2019’s result is probably going to be quite poor with costs associated with shutting down StarMetro and there isn’t any good news at all other than the federal government subsidizing the business with digital media and journalism tax credits.

Valuation

The company’s Class B shares traded last Friday at 43 cents per share, which gives it a market capitalization of $35 million. In happier times (in 2011) the company traded as high as $15/share. It has spent most of 2019 under $1, and so far in 2020, it has been under 50 cents.

The question at the end of the day is whether the entity can sustainably generate cash. I believe the answer to this is yes. The question is how much the underlying business has to shrink in order for them to get to that point, and whether management can execute on structuring a leaner organization to doing so. That remains to be seen, but things right now are priced for a huge amount of pessimism relative to their market capitalization. The range of outcomes in my books are them going slowly to zero to being able to recover to a much higher market capitalization – when using a linear probability curve, the expected value is higher than 40 cents per share.

The big kicker is the ticking clock on dividend payments, which I think will give the board of directors incentive to tell management to get going. In the event they want to save themselves, they will give a 15 cent per share dividend by Q3-2021, which will mean I at least get paid to wait. If not, I’m sure Prem Watsa will have better ideas.

To repeat, I have a very small position in Torstar. If they pull off a miracle and get back to a $250 million market capitalization, it will be a welcome boost to the portfolio. If it’s clear that things are going from “really bad” today to “really really bad with no hope”, I’ll take a couple lumps on the head but it won’t cripple my portfolio by any extent.

If you do trade this, be warned that liquidity is not the greatest. It typically trades around $10,000 in volume a day, and the 2 cent spread you typically see in the stock represents a 5% price difference so selling at the bid and buying at the ask is very expensive if you are impatient!