Equity – Page 12

Revisiting ARCH

ARCH has been up and down like a yo-yo for the past half-year, ranging from roughly its current lows of 115 to a high of about 170 per share.

They have been able to cash in significantly in the post-Covid metallurgical coal boom, which is also instigated by the lack of capital invested in the industry.

I’ve been revisiting the math with this company.

I made some significant projection errors with my previous April 26, 2022 post. I improperly accounted for the shares outstanding (16 million vs. 19.8 million actual) and also underestimated the cash collection cycle when it come to the Q2 dividend. I was off by a mile, estimating an $11.60 dividend when it was actually $6.00! In fairness to my projection, the company did earn about $25/share on my mistaken input of 16 million shares, but they allocated some excess dividend cash to asset retirement.

I’ve sharpened my pencils since then and hopefully will be a little more precise. While at times I can be a spreadsheet warrior and try to calculate numbers to the nearest decimal point, investment analysis is a really strange business where in most cases it is intellectually wasteful to try to be exactly correct, but optimally be mostly correct with your assumptions and directions. We will apply the same standards here.

Balance sheet-wise, ARCH ended Q2 with approximately $191 million net cash, not including the $100 million they stashed away for asset retirement obligations. This assumes the capped call transaction is cashed in, and the convertible debt is converted. This positive net cash value represents about 10% of the market cap of the company, although for the purposes of this analysis we will make a conservative assumption and ignore the net cash on the balance sheet.

We will use 19.8 million shares as the denominator, although it is quite possible ARCH did perform share buybacks in Q3.

The key statistic in Q2 was the average met coal sales price of US$286 per ton. They already have committed sales in North America for US$216, and seaborne for US$284. The rest is spot sales, which for most part should be at comparative prices.

I see that Australian coking coal futures are trading around US$264 spot and US$310 for Q1-2023 coal (quite the contango).

The point is that Q3 met coal sales pricing should be around the ballpark as Q2, or about $400 million in net income.

This time, however, the company will have fully funded the reclamation funds and paid down the debt, so they can fully utilize the free cash flow for the 50/50 capital allocation model (half to dividends and the other half to either buybacks, capital preservation or the like). In Q2 the dividend was reduced by $40 million (~$2/share) than it otherwise should have been due to the $80 million contributed to asset retirement.

ARCH should be able to give off about $9/share in their Q3 dividend, based off of approximately $360 million in distributable cash. I am guessing that their accounts receivable balance will not bloat further during the quarter.

This will make the three-quarter average for dividends $7.75/share, or $31/share annualized.

Recall this is half of the company’s distributable cash flows, which annualized is about 27% of the current share price (US$115/share).

The company will probably dump the majority of the other half of free cash flow into share buybacks. Needless to say, at a price of a 27% implied yield and in a net cash situation, I do not disagree with using capital for buybacks. Even if they are the worst market timers on the planet, they would have bought back a million shares this quarter, which would take out 5% of the shares outstanding and they would be able to jack up the dividend even further – to about $9.50/share.

At US$280/ton for met coal prices, ARCH is a cash generating machine. The margin of safety is quite high.

However, many dead bodies are littered on the road of purchasing commodity stocks after cycle highs. If the world is heading into an interest rate induced global economic recession, it does not bode well for steel production, which in turn would sap demand for metallurgical coal production. Current indications suggest a mixed environment, which bodes well for future returns.

The only real threat, other than raw commodity pricing, is their tax shield. At the end of 2021, ARCH had reserved $500 million for a valuation allowance with respect to their income taxes. In the first half of 2022, they went through $120 million of this, which will result in their tax shield expiring around Q4-2023 at the current pace of their earnings. The blended tax rate for ARCH would be approximately 28% when this kicks in – reducing the returns significantly for 2024 and beyond, but still a very healthy amount.

Diversification

There are events that you just can’t predict, such as having to deal with malware on your web server.

This week has been full of them, and it is only Wednesday.

Teck (TSX: TECK.B) announced on the evening of September 20 that their Elkview coal plant (their major metallurgical coal operation) had a failure of their plant conveyor belt and it would be out of commission for one to two months. If out for two months, this would result in a loss of 1.5 million tonnes of coal. Considering that they can get around US$400/tonne for their product, and very generously they can mine it for US$100, this is a huge hit. Not helping is that one export terminal (Westshore (TSX: WTE)) is going on strike, but fortunately Teck managed to diversify from this operation last year with their own coal loading terminal!

Cenovus (TSX: CVE) owns 50% of a refinery in Toledo, Ohio. BP owns the other half, and they are the operating partner. There was a story how a fire at the plant resulted in the deaths of two workers, and the refinery has been shut down to investigate. Making this more complicated is that on August 8, 2022, Cenovus announced they will be acquiring the other 50% of the refinery for US$300 million in cash. Ironically in the release, it is stated “The Toledo Refinery recently completed a major, once in five years turnaround. Funded through the joint venture, the turnaround will improve operational reliability.”

Given the elevated level of crack spreads and the 150,000 barrel/day throughput of the refinery, the cost of this fire will not be trivial, and quite possibly will involve an adjustment to the closing price.

The point of these two stories is that there can be some one shot, company-specific event that can potentially affect your holdings – if there are other options in the sector you’re interested in investing in, definitely explore them and take appropriate action. Teck and Cenovus are very well diversified firms, but if you own an operation that has heavy reliance on a single asset (a good example would be when MEG Energy’s Christina Lake upgrade did not go as expected a few months ago), be really careful as to your concentration risk of such assets.

On a side note, have any of you noticed that many, many elevators are out of commission in publicly-accessible buildings? It’s like expertise in anything specialized is simply disappearing – it makes you wonder whether the maintenance operations of the above companies (and many others not listed in this post) are being run by inexperienced staff.

Cenovus Energy’s relatively small dividend

Cenovus Energy (TSX: CVE) is Canada’s second largest oil producer (behind CNQ), featuring two flagship oil sands projects, Christina Lake and Foster Creek. Unlike CNQ, they have downstream capacity just a shade short of their production levels. Needless to say they have been producing a lot of cash flow.

Compared to the top three (CNQ, Suncor and CVE), Cenovus’ dividend has been relatively paltry – the yield has been less than 2% and a very small fraction of the company’s free cash flow.

You might have been wondering why, and it likely concerns the warrant indenture. Specifically, the warrants have a price adjustment if “Dividends paid in the ordinary course” exceeds a certain level:

in the aggregate, the greater of: (i) (a) for the 2021 financial year, $170 million; and (b) for financial years after 2021, 150% of the aggregate amount of the dividends paid by the Corporation on its Common Shares in its immediately preceding financial year which were Dividends Paid in the Ordinary Course for such preceding year;
(ii) 100% of the retained earnings of the Corporation as at the end of its immediately preceding financial year; and
(iii) 100% of the aggregate consolidated net earnings of the Corporation, determined before computation of extraordinary items but after dividends paid on all Common Shares and first preferred shares of the Corporation, for its immediately preceding financial year, in each case calculated in accordance with Canadian generally accepted accounting principles consistent with those applied in the preparation of the most recently completed audited consolidated financial statements of the Corporation;

The relevant clause for 2021 is retained earnings, and it was $878 million at the end of 2021. $878 million divided by 2.016 billion shares outstanding gives you about 43 cents per share, and CVE’s current dividend was raised to 42 cents per share.

For the first half of 2022, retained earnings is sitting at $4.6 billion and this will likely go much higher by year-end. At June 30, CVE had 1.97 billion shares outstanding and thus they can practically increase their regular dividend to match their cash flow once the audited financial statements are released in March of 2023. Until then, they are stuck with their existing dividend and are busy buying back shares and paying down debt in the meantime, in addition to consolidating the 50% share in the Sunrise oil sands and Toledo refinery that they previously did not own. Once they get down to their $4 billion debt target, the company pledged to distribute 100% of its earnings to shareholders – practically behaving like an income trust if you remember those days when Penn West and Pengrowth income trusts were throwing out the cashflow in a similar manner. An annualized $2/share dividend is not out of the question, and this would likely result in the stock trading for higher than what it is currently trading for today.

Today’s contrarian sector – European Banks

This is likely in the “not yet” category, but it is something that I’m paying a little more attention to than most, namely the big European banks.

With the EU reacting to its poor energy policies by enacting demand restrictions, there will surely be further reverberations going forward in terms of the continent’s heavy industry. This will have spin-off impacts in terms of the credit that is extended to various corporations that are sensitive to energy input costs, and creating a whole financial cascade. Who ever thought that negative interest rates would actually have real consequences?

With that said, I’ve looked at various European banking entities, and just doing the most superficial analysis. Numbers are market cap (US billions), P/E, P/B and historical dividend yield.

UK
LYG: Lloyds Banking Group – 33 / 6.6 / 0.57 / 3.9%
BCS: Barclays PLC – 31 / 5.1 / 0.38 / 2.8%

France
BNPQY: BNP Paribas – 57 / 5.6 / 0.49 / 8.5%
SCGLY: Societe Generale – 18 / 7.0 / 0.28 / 8.0%

Germany
DB: Deutsche Bank – 17 / 5.4 / 0.25 / 2.7%
CRZBY: Commerzbank – 8 / 4.9 / 0.28 / 0%

Italy
ISNPY: Intesa Sanpaolo – 33 / 8.8 / 0.51 / 7.0%
UNCRY: Unicredit – 19 / 25.6 / 0.30 / 3.9%

Spain
SAN: Banco Santander – 39 / 4.6 / 0.44 / 4.6%
BBVA: Banco Bilbao Vizcaya Argentaria – 28 / 4.6 / 0.62 / 11.3%

Scandinavia
NRDBY: Nordea Bank (Finland) – 34 / 10 / 1.1 / 16.7%
DNBBY: DNB Bank (Norway) – 29 / 9.9 / 1.17 / 5.6%
SVNLY: Svenska Handelsbanken (Sweden) – 16 / 7.4 / 0.89 / 6.8%

Other notables
UBS: UBS Group (Switzerland) – 55 / 7.0 / 0.97 / 1.6%
ING: ING Group (Netherlands) – 32 / 7.8 / 0.62 / 4.0%

Note that all of the institutions above have international operations and hence they are not entirely exposed to the risks of their domestic markets.

Let’s compare this to Canada (market cap is in billions of USD):

Canada
RY: Royal Bank: 130 / 10.8 / 1.8 / 4.2%
TD: Toronto Dominion: 118 / 10.7 / 1.6 / 4.2%
BMO: Bank of Montreal: 63 / 7.3 / 1.7 / 4.6%
BNS: Bank of Nova Scotia: 65 / 8.7 / 1.3 / 5.8%
CM: Canadian Imperial Bank of Commerce: 43 / 9.4 / 1.3 / 5.4%

One immediate observation is that Canadian banks have much larger market capitalization than their European counterparts. Indeed, looking at the global picture, the USA and China have the largest banks by market capitalization, while the largest European one is BNP, very much behind in the standings.

Needless to say, some of these European bank valuations look compelling at a glance. However, to do the proper analysis of these large (and for the most part, incredibly opaque) institutions, one has to have a grasp on whether their loan portfolios will actually perform and to get a sense of where the geopolitical risks lie. But overall, Europe is trading like a disaster at the moment for obvious reasons (they are a slow-moving financial train wreck happening at the present time) – if, for whatever reason, it is better than a disaster, there perhaps may be some gains to be had in the future from the current depressed levels.

Unfortunately I am not skilled enough to make a nuanced differentiated bet on any specific company above – there are tons of analysts working in the usual institutions that are properly able to gain an edge on which of the above will do better than the rest, but my suspicion is that at some point, an unsophisticated player like myself can probably generate some alpha by constructing an equal-weighted ETF of some of the components above.

I do think I have a better “home field advantage” with the Canadian banks above, but that home field advantage tells me to back off for better values in the future. As far as Europe goes, however, the time is likely closer to a reasonable value bet.

That said, you may wish to disregard anything I say on international bank stocks simply because it does not look like that my investment in Sberbank (a couple days before the sanctions hit) will be materializing anytime soon – my largest one-shot loss in my investing history, assuming it goes to zero (which it effectively is at the moment for non-Russian investors).

Yellow Pages’ peculiar share buyback

Yellow Pages (TSX: Y), a long-time holding of mine, announced their second quarter results a couple weeks ago.

There were some interesting highlights involved, namely that this quarter was the first quarter in a very, very, VERY long time where they had a sequential increase in revenues between quarters (albeit, the profitability of such revenues decreased as the mix had more lower margin revenues). This got very little recognition.

The actual cash generation figures have still been quite healthy, although this is the first full year where Yellow’s tax shield has whittled away to only partially offset their income. By virtue of making some seriously questionable past acquisitions (before the belt-tightening regime of the existing management) they are allowed to deduct a declining balance amount on their cumulative eligible property, which is better than nothing.

However, the highlight is what is essentially a forced share buyback:

The Board has approved a distribution to shareholders of approximately $100 million by way of a share repurchase from all shareholders pursuant to a statutory arrangement under the Business Corporations Act ( British Columbia ). The arrangement will be effected pursuant to a plan of arrangement which provides that the Company will repurchase from shareholders pro rata an aggregate of 7,949,125 common shares at a purchase price of $12.58 per share, which represents the volume weighted average price for the five consecutive trading days ending the trading day immediately prior to August 5, 2022.

The proposal requires 2/3rds of the shareholders to approve, but they already have consent from the three major shareholders (GoldenTree with 31%, Empyrean with 24% and Canso with 23%) to proceed. Minority shareholders (such as myself) are along for the ride, although because the buyback is proportional, no entity will have a different level of ownership after the transaction (restricted share units, options, etc., typically have clauses to reflect such special distributions).

At the end of June 30, Yellow had 26,607,424 shares outstanding. This works out to a distribution of $3.76/share.

The way I understand it, instead of the entire amount consisting of an eligible dividend, it will effectively amount to a sale of 30% of the stock, which means that the cost basis of such shares can be deducted against the proceeds of the sale (for most people, this will be a capital gain). If my understanding of the tax treatment is correct, then the tax burden of such a distribution will be significantly less than the typical special dividend.

However, in the letter to the three top shareholders, the following paragraph is in there:

The Company agrees that it shall designate the full amount of any dividend deemed to arise under the Income Tax Act (Canada) as a result of the acquisition of the Common Shares pursuant to the Arrangement as an “eligible dividend” pursuant to subsection 89(14) of the Income Tax Act (Canada) and the corresponding provisions of any provincial tax legislation pertaining to eligible dividends.

As those three entities own more than 10% of the common stock of the company, such a distribution would be tax-free if given to their CCPC subsidiaries if classified as such. I am not sure whether differential tax treatment is permitting. When the company’s management information circular comes out, reading the tax opinion will be educational as I have never encountered this ‘forced buyback’ in my investing life.