Category: Canada

Holloway Lodging REIT – debt conversion

Following up from my previous post on Holloway Lodging’s (TSX: HLR.UN) debt situation, I notice on December 22, 2011 they gave a conversion notice of their debentures to units:

Holloway Lodging Real Estate Investment Trust (TSX: HLR.UN HLR.DB.A) (“Holloway” or the “REIT”) announces that it has today given notice to the holders (the “Debentureholders”) of its 6.5% convertible unsecured subordinated debentures (the “Debentures”) that it will redeem the Debentures in full on January 23, 2012 and that it will satisfy the redemption price of the Debentures on the redemption date by issuing trust units (“Units”) of the REIT in lieu of cash, in accordance with the terms of the trust indenture for the Debentures (the “Indenture”). Any accrued and unpaid interest on the Debentures will be paid in cash on the redemption date.

…

The number of Units to be issued to Debentureholders will be determined by dividing the aggregate principal amount of Debentures outstanding by 95% of the weighted average trading price per Unit for the 20 consecutive trading days ending on the fifth trading day preceding the redemption date (the “Current Market Price”). Based on the redemption date of January 23, 2012, the 20-trading day period commenced on and included December 15, 2011 and will end on and include January 16, 2012.

…

Holloway also announces that it will not make the interest payment on its Debentures when such payment is due on December 31, 2011. Holloway intends to make such payment by January 13, 2012, as permitted by the terms of the Indenture.

This is a significant development for unitholders in that the roughly $51.8M face value of debentures outstanding (at least as reported by the TSX; this may be slightly lower due to buybacks) will be converted at the rate of approximately 7-8 cents per share, at least given existing trading patterns to date. Unit prices cratered from 20 cents to as low as 4 cents upon the announcement (currently trading at 10 cents), while debenture prices dropped from 58 cents to as low as 40 cents and is currently at 53 cents on the dollar.

Assuming an 8 cent per unit conversion price, this would mean dilution of about 94% for existing unitholders. Somebody holding $1,000 face value of debentures would receive 12,500 units, implying a unit price of about 4.25 cents post-conversion. The remaining entity will have about 670 million units outstanding and at 4.25 cents per unit it would imply a market capitalization of about 28 million.

Using the 2010 cash flow statement as a very blunt proxy for future performance, the entity without the convertible debentures will be able to pull in about $5.9 million in operating cash flow, which would put it on sounder financial footing. It could suggest that the post-conversion trading price of the units will be around 7-8 cents.

Finally, the company has decided to consolidate the remainder of its non-mortgage debt on the chairman’s company Geosam:

Holloway also announces that it has entered into a second amendment to its credit agreement dated as of June 15, 2011 among Holloway, Geosam Capital Inc. (“Geosam”), as administrative agent, and Geosam, together with such other persons from time to time party to the credit agreement, as lenders, (the “Credit Agreement”) to increase the amount of funds available for drawdown by $3.6mn for certain limited purposes. Holloway has increased the amount outstanding under the Credit Agreement by $1.8mn in order to purchase from the holders of its interest-bearing promissory notes approximately $2.8mn of such notes, representing all of Holloway’s interest-bearing promissory notes outstanding.

This is presumably linked to the resignation of the CEO (Squires) that lasted in the company longer than I expected him to after the takeover of the company by George Aryoman and Geosam.

My conclusion here is that the market is valuing the debentures and units as slightly expensive, but it is within an order of magnitude of a fair valuation. Finally, my continuing thesis is that the only entity that will make any money from Holloway will be Aryoman and Geosam by virtue of their control of the company and the secured credit facility which will continue to hive off interest income from Holloway unitholders. This will continue as the assets are stripped and sold from the trust.

In other words, this is a fun one to watch, but not to invest in. I feel fortunate to dump my debentures at the price that I got for them (roughly 60-65 cents) and get out of dodge. If unit prices go down to the 4 cent level again, the trust may be worth putting a few pennies in, but this would be one of those typical “pick up the cigar butt off the street for one last puff” type value plays.

Back from holidays

I am back from my 6-week vacation outside the country (where the weather was much, much warmer) and will hopefully get back into mental shape to post about some projections for 2012, the performance in 2011 (not good!) and other such worldly things.

One thing I do know, however, is that unwinding from an extended stay out of the country takes a long time, and recovering from a 16 hour time change is not pleasant!

Government Bond yields have dropped significantly

The one impact of the US debt ceiling extension has been that government bond yields have dropped significantly over the past week. For instance, the 10-year Canadian government bond benchmark has lost about 25 basis points which is a huge drop:

10-year bond yields are now lower now than they have been since January 2009 (the depths of the financial crisis). The bond markets are highly pessimistic about any form of economic recovery and are trading as such.

Short term rates are no longer pricing in a sure chance of a rate increase – BAX futures are as follows:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 11 AU 0.000 0.000 98.670 0.000 0
+ 11 SE 98.685 98.690 98.685 0.000 23202
+ 11 OC 0.000 0.000 98.655 0.000 0
+ 11 DE 98.660 98.670 98.660 0.010 42832
+ 12 MR 98.630 98.640 98.610 0.020 35992
+ 12 JN 98.590 98.610 98.560 0.040 16408
+ 12 SE 98.550 98.570 98.510 0.050 7649
+ 12 DE 98.500 98.510 98.450 0.060 2729

The December BAX Futures are at 98.66 (1.34%) compared to 98.46 (1.54%) when the Bank of Canada made its last pronouncement on short term rates.  It no longer appears that short term rates will be rising at all.  Three month corporate paper is still at 1.17%.  If there is any hint of economic recovery, it is not seen in the bond market.

Bank of Canada sending out a warning signal

The Bank of Canada kept their target interest rate steady at 1%, but ominously sent out a signal as follows:

Reflecting all of these factors, the Bank has decided to maintain the target for the overnight rate at 1 per cent. To the extent that the expansion continues and the current material excess supply in the economy is gradually absorbed, some of the considerable monetary policy stimulus currently in place will be withdrawn, consistent with achieving the 2 per cent inflation target. Such reduction would need to be carefully considered.

The Greenspan-esque interpretation of the tea leaves will point out that prior wording stated “eventually will be withdrawn” while this press release states that it is approaching if the rest of the financial world does not implode.

When reading the more detailed Monetary Policy Report, two charts came to mind:

Total CPI is increasing significantly – it is no surprise to hear this as commodity prices continue to shoot up like a rocket and prices are passed along the supply chain.

Finally, BAX futures shot down for the year-end interest rate – at 98.46 (1.54%) compared to 98.61 a week ago. This is projecting a near-certainty of a 0.25% rate increase by years’ end.

If short term interest rates rise and the yield curve continues to flatten (10-year rates are still at 2.89% even after the bank rate announcement), this will start to have interesting effects on “yieldy” equities as the leveraged bet starts to become less profitable. There are also implications for the real estate market that I won’t be getting into at this time.

Microcap fishing – Audiotech Healthcare, Spot Coffee

I have spent the better part of the day doing some screening and research on microcap companies (generally those with market capitalizations of under CAD$50 million). I discarded most of the energy and mineral-type firms as these firms are generally impossible for third-parties to get any sort of edge on.

Finding good microcap companies reminds me of the process of mining for bitcoins – you can spend hours (and days) doing it, but still end up with nothing. That was pretty close to what the last half day of my life feels like.

When doing some intermediate analysis on 9 companies, one managed to clear the necessary thresholds for “interestingness” on my watchlist, although this was not a case that screamed at me as a company that will see 5-fold increases in its equity prices. It would be considered a value play. I set a price target that was roughly 20% under what it was currently trading as this would be a valuation that I would be interested in doing some more extensive due diligence for a potential purchase (although it would be a small allocation if it ever got to that point). I will receive an email if it reaches this price threshold.

However, there were two interesting “discards” that I will share.

The first company is Audiotech Healthcare (TSX: AUD), which operates a few hearing clinics in more remote areas of BC, Alberta and the USA. They are family run and family-controlled and stable and profitable. Their balance sheet is in OK shape, with sufficient cash on hand to cover upcoming debt maturities and otherwise not polluted with massive goodwill (indeed, none). Management is relatively respectful of shareholder value (likely due to its significant economic interest in the company) and related party transactions are at an acceptable level (the worst of it is a dead real estate lease in Calgary which will likely be off the books soon). Valuation is relatively cheap, with recent business performance in the last fiscal year producing $347,000 in free cash flow on a (undiluted) market capitalization of $2.38 million. They are ripe to go private or to be consolidated by a larger player.

Unfortunately, their shares are completely illiquid. With $10,000 in volume traded over the past 30 days, a single trader can probably take the stock price up 50% in a day. Hence, this company is in the “interesting but not practical” list of investment candidates.

The next company that I had to do a double-take on is a little more strange. Spot Coffee (Canada) (TSX: SPP) operates coffee franchises, not too dissimilar from Blenz, Waves, Second Cup and Starbucks, in locations in Western New York state, Toronto and one location in Florida. The only difference is that they appear to be larger scale than the typical Starbucks chains and they also serve slightly more complex food offerings.

What is particularly strange is that when you read the management/director biographies, you ask yourself “What the heck are these people getting into this business for?”. I will post the following from their most recent management information circular and let you come to your own conclusions:

The company itself seems to be financed mostly with equity, with the company raising equity capital through private offerings as the need arises. The last private placement was at 10 cents per share for $500,000 and warrants to purchase shares at 15 cents a piece expiring in 3 years. The current market value is $8.6 million and 13.5 cents per share. Operationally they are losing money, but this is due to the lack of economies of scale associated with having such a geographically dispersed operation and relatively low numbers of operating coffee shops.

Gross profit margins have been improving – the most recent quarter being 73%, which is a good improvement over the previous year. Presumably if they manage to scale up their sales in other locations they can actually start to make money, but I haven’t bothered doing the breakeven calculations. This is investing in an industry that is already well established.

Although I won’t be touching the equity on this company, something makes me suspect that this company might be the recipient of some “hype valuation” if they continue opening more stores, sort of akin to Caribou Coffee (Nasdaq: CBOU).

That concludes my investment research for the day – little to show for it.