Canadian Finance and Economics
I posted earlier about John Hempton “outing” a Chinese-based company that claimed to be an internet travel agency when it really was not.
Want to guess when the post went on the internet?
I would love efficient market hypothesis proponents to explain this one.
John Hempton has a classic story of his research on an “online” travel agency.
My rule of “Never invest in a jurisdiction that does not have English as its primary language” holds very, very true. I am sure there are a lot of wildly profitable companies in China, just that you can be absolutely sure that minority shareholders’ interests (i.e. the suckers that buy a few hundred shares to have a “China play”) will never be in alignment with the board of directors or management. In this particular case, UTA looks great on paper, but is likely their accounting and reporting is completely crooked.
In their last 10-K filing, you even had the auditors (a firm I’ve never heard of in New Jersey) saying in their audit letter the following:
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. The following material weaknesses were identified:
The Company’s policy documentation of all controls identified during their assessment and remediation process was incomplete.
Lack of technical accounting expertise among financial staff regarding US GAAP and the requirements of the PCAOB, and regarding preparation of financial statements.
These material weaknesses were considered in determining the nature, timing, and extent of audit tests applied in our audit of the 2009 consolidated financial statements of the Company as of and for the year ended December 31, 2009.
Translation: “We have no idea whether these guys were lying to us when they provided us with alledged ‘proof’ of the revenues, expenses and balance sheet items you see here. Good luck!”
Suffice to say, I wonder if Hempton (who has probably made a small fortune shorting this thing earlier when the stock was trading higher before writing this huge article on the company) will be able to single-handedly get the stock delisted when his 2,200 readers (at least according to Google Reader) eventually hammer the stock down to the zero it probably deserves.
Just for full disclosure, I am not long or short the stock, nor do I plan on trading the stock. Trading from other people’s research is a great way to lose money – capturing real value in the market is done by performing independent research when nobody else is watching.
Headlines are being made that Lululemon (Nasdaq: LULU) beat earnings expectations and raised income estimates for the year. Their common shares were up about 13% today after their second quarter report.
Most of what I wrote about Lululemon, in terms of share valuation back in June 10, 2010 (when they announced their first quarter results) applies today – the company will have to execute high growth perfectly in order to justify their existing valuation.
It should be pointed out that despite their second quarter surprise, their valuation around the same ($2.8-$2.9 billion) as it was when I wrote my June 10 article, or about USD$40/share. They will need to continue achieving rapid growth in order to grow into the existing valuation. If not, you will see a significant haircut in the stock price.
Lululemon is a classic case of a well-run company that you do not want to own stock in.
Clearwater Seafoods Income Fund (TSX: CLR-UN.TO) is a financially distressed entity. The fund has an equity interest in a limited partnership. The limited partnership is the operating business that sells seafood. The units are trading at around 80 cents, with a market capitalization of about $23 million. The trust has stopped paying distributions since 2007 and is not likely to pay distributions for a long, long time.
Whenever investing in an income trust, they typically have more complicated ownership structures than corporations. You can usually get a summary of the structure in the first few pages of the annual information form. I have extracted a diagram which illustrates the relationship between the fund and the operating entity:
Whenever I see something like this, I think negatively since usually such structures exist to give certain (usually founding) entities control over the operating assets, but to distribute the economic interests to other parties that is not in proportion to voting interests. In this case, the unitholders of Clearwater Seafoods Income Fund are simply there for the ride by virtue of having a 54% voting interest in a very indirect say as to what goes on at the operating level. As a result, an investor would need extra compensation (i.e. higher reward) for the extra risk that they are taking (the risk that their interests are not going to be in alignment with the people holding the puppet strings).
Clearwater also has a debt problem – as of June 30, 2010 the operating entity has about $218 million in debt outstanding, and of this debt, the trust has lent the operating entity $45 million in exchange for partnership units (they have also done this in other instances with different terms and maturity dates). This loan matures in December 31, 2010. The operating entity also does not generate enough cash, nor are there other assets readily available to pay off the debt. As a result, the company will have to find external financing or find some method to recapitalize the debt.
There is also another $11.3 million loan that is due in September 2010.
In the management discussion and analysis, we have the following paragraph:
In December 2010 Clearwater Seafoods Income Fund has $45 million of convertible debentures that come due. These funds were invested by the Fund in Class C Units issued by Clearwater with similar terms and conditions, including maturity in December 2010. Clearwater also has approximately 1.3 billion in ISK denominated bonds, including CPI and accrued interest that come due in September 2010 (approximately Canadian $11.3 million at July 3, 2010). Clearwater is currently investigating refinancing alternatives and plans to refinance both before the respective maturity dates.
When we look at the market for the $45 million debenture, we see it is trading at 88.5 cents on the dollar. So the market is heavily betting that the debt will be refinanced at relatively favourable terms to debt investors. Recapitalization, however, appears to be out of the question since it would require relinquishing control to the debtholders and the current market value of the units is far too low to make a direct conversion worthwhile. Going into bankruptcy protection might occur if the debtholders and trustees cannot come to a mutually equitable arrangement.
Given the lackluster cash flow from operations, the complexity of the trust and underlying operating entities, and obvious credit risk, I will be watching this one purely from the sidelines to see how this mess gets resolved. My cursory look at the situation would suggest that the debt and equity are both overvalued.
The following chart is a brief list of the top-10 sized oil and gas companies in Canada, and their year-to-date performance ended September 1, 2010, not including the impact of dividends (which would be significant in the cases of COS and PWT which distribute most of their income through their trust structure):
| Name | Ticker | %-YTD |
| Suncor Energy Inc. | SU | -9.35% |
| Canadian Natural Resources Limited | CNQ | -7.63% |
| Imperial Oil Limited | IMO | -2.73% |
| Husky Energy Inc. | HSE | -16.42% |
| EnCana Corporation | ECA | -13.19% |
| Cenovus Energy Inc | CVE | 11.66% |
| Talisman Energy Inc. | TLM | -13.00% |
| Canadian Oil Sands Trust | COS | -14.04% |
| Nexen Inc. | NXY | -19.27% |
| Penn West Energy Trust | PWT | 6.09% |
Cenovus is clearly the winner here – investors are quite happy with parking capital into non-conventional Canadian oil. It is surprising that Suncor has not fared better, probably due to integration concerns with Petro Canada. Husky Energy and Nexen have been the worst performers. Husky has had a significant management change and appears to be in petrochemical limbo with no obvious growth. Nexen has Gulf of Mexico exposure and this can explain its performance.
It should be important to distinguish the difference between oil and gas – gas commodities have been priced significantly less than oil over the past couple of years, so EnCana and other gas-concentrated producers should lag the oil companies at present.
Finally, there are likely many more analysts out there that follow these ten companies that are much more knowledgeable about the individual companies and their exploration properties, so it is unlikely that by mining the relative price data that there can be any value extracted from this very simple analysis. It does tell you which companies have had lowered and raised expectations since the beginning of the year, however.