Canada – Page 33

Bank of Canada Interest Rate Projections

Since the last 0.25% rate increase on July 20, the bankers’ acceptance futures have been quite calm. We have the following quotations:

Month / Strike	Bid Price	Ask Price	Settl. Price	Net Change	Vol.
+ 10 AU	0.000	0.000	98.905	-0.005	0
+ 10 SE	98.825	98.835	98.825	0.000	1825
+ 10 OC	0.000	0.000	98.725	-0.005	0
+ 10 DE	98.700	98.710	98.700	0.010	6190
+ 11 MR	98.580	98.590	98.580	0.010	4636
+ 11 JN	98.460	98.470	98.460	0.010	2213
+ 11 SE	98.310	98.320	98.310	0.000	904
+ 11 DE	98.140	98.150	98.130	0.010	303
+ 12 MR	97.950	97.960	97.940	0.020	104
+ 12 JN	97.770	97.790	97.760	0.020	54

This still hints that the short term rate will rise 0.25% by the September 8 or October 20 meeting, and the short term rate will end the year at 1.00% with a possibility of 1.25%. For the year 2011, rates are expected to inch higher by about 0.5 to 0.75%.

It should also be noted that at present, 3-month corporate paper is yielding 0.89%. This was approximately 0.4% half a year ago.

Finally, since 5-year bond rates have dropped considerably over the same time period (which is counter-intuitive to the economics 101 texts that state that longer-term bond yields will rise with an increase in interest rates), 5-year fixed term mortgages should also drop – the best one I can see so far is 3.87%.

Menu Foods cashes out

Menu Foods is a manufacturer of pet food. They are most famous for an incident in early 2008 where some chemical got into their food supply through imported grain from China which was tainted and caused organ failures in pets. Although they were already on the financial skids in a very low-margin industry (they cut distributions to zero in 2005), this tainted food incident took down their share price down to abysmally low levels and presented a considerable financial risk for equity holders since the company was on the brink of insolvency.

They did manage to stage a partial recovery, but then the global economic crisis hit later in 2008 and early 2009, which brought the common shares once again around the 70-90 cent range.

Investors back then, buying equity, were taking an incredible risk, but it is one that has paid off for them – although the business produces cash flows today, it is slim and they have high leverage given the amount of cash they generate. Still, an investor taking the plunge at a dollar would have seen last Friday over a triple gain on their equity investment.

Today, they will be bought out for $4.80/unit, which if I was holding units, would be selling out with a smile on my face.

I remember looking at the company back in early 2008 and thought they were going to go bankrupt. I also did not put this firm on my candidate list during the economic crisis simply because there were so many other (more solvent) offerings on the market at the time.

Another example of yield chasing

Just after a week since I posted a review of Superior Plus, declaring that they probably would have to reduce their dividends in order to be financially sustainable, they announced their quarterly results today. Notably, they lowered expectations for 2010 due to warmer weather (and therefore less natural gas deliveries).

They also had the following snippet in their quarterly release:

– The financial outlook for 2010 has been revised to AOCF per share of $1.50 to $1.65 as a result of lower than anticipated second quarter results and a weaker than previously anticipated economic recovery for the remainder of 2010.

– The financial outlook for 2011 has been revised to AOCF per share of $1.85 to $2.05 as a result of a weaker than previously anticipated economic recovery forecasted for the remainder of 2010 and throughout 2011, particularly impacting Superior’s Construction Products Distribution business.

AOCF is “Adjusted operating cash flow”, which is a non-GAAP metric to approximate how much cash before capital expenditures is available to the corporation. Since their dividend rate is $1.62/share, this leaves the company little to negative real cash to provide for acquisitions (which they have done plenty of over the past couple years), debt repayment or capital projects.

The company’s stock traded down 7.9% as a reaction to their disappointing report.

Investors undoubtedly will be looking at Superior Plus’s 13.03% dividend yield and marvel what a bargain they are getting, but it seems likely they will be forced to reduce dividends and this is reflected in the market price.

Interestingly enough, Superior Plus has four issues of debentures that trade on the TSX – the issue maturing in December 2012 has a yield to maturity of 4.5%, while the issue maturing July 2017 has a yield to maturity of 5.9%. They appear to be priced very expensive and I would not touch them.

Dividend payouts is not a reliable financial metric

I note that Manitoba Telecom, a boring but profitable firm providing telecommunication services in Manitoba, released their quarterly results today with a dividend cut – from $2.60/share to $1.70/share, paid quarterly.

With 65 million shares outstanding, this amounted to a reduction from $169M/year to $111M/year.

Given its free cash flow, which is now estimated to be around $160-190 million, this is a rational decision by management because it will give the company some room to either build up cash reserves or de-leverage from its approximate billion dollar long-term debt balance.

The market took down the common stock from $27.32/share to $24.98/share. Part of this is due to the reduction in expected earnings, but also likely due to investors bailing out on the payout cut.

The important lesson for an investor is that you cannot just look at the dividend yield and assume it will be stable – the company must be able to make enough cash, plus enough for future capital expenditures and debt repayments, in order to justify that dividend. Ultimately, the dividend itself is a metric that is should only weakly associated with the proper valuation of an equity security.

Manitoba Telecom has been on my watchlist for ages, but I still do not find any compelling value in the stock. This is another classic case of yield chasers getting burned.

BC Lower Mainland Real Estate liquidity drying up

Skimming the Greater Vancouver Real Estate, and the Fraser Valley Real Estate statistics packages, it is not surprising in the least to see volumes decline in the July month-to-month comparisons.

The reason is very simple – the introduction of the HST and the threat of higher interest rates. While HST has an impact on new homes sold, the threat of higher interest rates also pushed demand forward. Even though short term interest rates have a smaller impact on the longer-term fixed rates than most people think, it is likely that most financially unsophisticated people would think that rates (at least in the short run) are going up, so they must “lock” their purchases in today.

Usually the opposite thinking works better – the best time to buy real estate are when interest rates are high – since real estate is a credit-driven market, one would surmise that once credit becomes more expensive, real estate demand would drop and subsequently prices would have to lower in order for transactions to proceed.

If the 50% reduction in sales reported is sustained for the following year, you are bound to see price reductions as people that need liquidity in the short-term will be forced to reduce their asking prices. The people that are not urgently seeking liquidity are more likely to sit on their high asking prices and not have a transaction occur.

In terms of sheer valuation (costs vs. income potential/rent savings), Vancouver real estate is by far and away an expensive option. I’ve already explained some other intangible components to the valuation, but one major pillar of real estate has been its “safety” perception by the local populace. Once the “real estate is safe and/or never loses value” mantra disappears, you remove one of the intangible components of demand in the market.

I do not foresee a collapse in the market like we saw in certain USA markets, but a protracted period of time where the price level does not move and/or a slow downturn in prices is likely in the cards.