Equity – Page 14

Slate Office REIT – or my brief attempt at becoming a corporate raider

Slate Office REIT (TSX: SOT.UN), as the name implies, is a REIT specializing in office properties. It is mostly Canadian, with properties in Saskatchewan and provinces eastwards, a couple buildings in Chicago and 23 properties in….. Ireland.

Clearly geographic concentration is not one of the focuses of this REIT.

In terms of their traded units, it has been fairly sleepy. If you take a 10-year chart and stick your fingers over the Covid portion, the units have meandered around $4-5 and have not really broken out of this range.

In terms of distributed capital, before Covid they got the distribution up to about 0.0625/month (75 cents a year). This was dropped after February 2019, to its current level of 40 cents a year. The characterization of distributions over the past couple years has been about half capital gains, half return of capital.

If you believe the MD&A, the so-called “Core FFO” is around 53 cents for the TTM.

IFRS book value is well above the current market price. Rounding to the nearest $100 million, on September 30, the stated property value is $1.8 billion and stated debt $1.1 billion.

The market value of the units is about $360 million.

This is about as mundane a REIT as it gets. The acquisition of the Ireland properties was really a departure from the previous inclinations.

A very well known businessman, George Armoyan (who runs TSX: CKI) owns, via his controlled corporation (G2S2), a sizeable stake in SOT, approximately 15-16%. They represent by far the largest unitholder group in Slate Office REIT, much more than Slate Asset Management (the effective controllers of SOT at this point in time) itself.

G2S2 created a website with an amusing name, Clean the Slate which you can check out (and which will likely be taken down after the proxy battle is over).

You can read their website to view their justifications on October 20 and 26. Putting a long story short, SOT has a management agreement which gives it an incentive to acquire properties that are not necessarily economic for minority unitholders. G2S2 claimed that SOT’s recent financing of a property using a new convertible debenture issue (TSX: SOT.DB.B) is very dilutive given the conversion price is well below book value.

G2S2 requisitioned a meeting to elect 4 trustees and remove 5 incumbents, which would give it control. Their purported aim is to converge SOT’s market value with book.

This got me interested.

After doing some review, I bought some of the convertible debentures of SOT.

There are three issues of debt.

SOT.DB matures on February 28, 2023. Coupon 5.25%. Convertible at $10.53 (not going to happen). Outstanding: 28.75 million.
SOT.DB.A matures on December 31, 2026. Coupon 5.5%. Convertible at $6.50. Outstanding: 75 million.
SOT.DB.B matures on December 31, 2027. Coupon 7.5%. Convertible at $5.50. Outstanding: $45 million. G2S2 also bought $7.1 million of this offering.

I attempted to get some of the .DB and .DB.B tranche, just a little bit. The bid-ask is reasonably narrow, but I have an aversion to hitting the ask unless if the situation really warranted it. I obtained a ‘starter’ position but could not accumulate more – the price is very narrowly traded. The trade ‘felt’ crowded.

After receiving a requisition for a meeting from G2S2 (October 27, 2022), I quickly glossed over the declaration of trust.

SOT had 21 days to reply to the requisition. This allows for some negotiation to occur.

Clearly such negotiations did not lead to much, as SOT announced on November 14 that they will hold simultaneously their special and annual general meeting on March 28, 2023. The cited excuse for the huge delay was:

The timing of the Meeting provides sufficient time for the Board to present information material to the unitholders of the REIT with respect to the items raised by the dissident unitholder, as well as information relevant to the previously announced review of strategic alternatives. The REIT intends to move up the timing of its Annual Meeting to combine it with the requisitioned Meeting, sparing unitholders the costs of the REIT hosting two separate meetings in quick succession.

Of course, I don’t believe any of this. This is a political battle and SOT is attempting to stack things as much in their favour as possible. Specifically they will want to dilute G2S2 to the extent possible, and also potentially extract as much value out of the asset base (even if they poison it) if Slate is going to lose it.

Clause 9.9 of the declaration of trust states:

For the purpose of determining the Unitholders who are entitled to receive notice of and vote at any meeting or any adjournment thereof or for the purpose of any other action, the Trustees may from time to time, without notice to the Unitholders, close the transfer books for such period, not exceeding 35 days, as the Trustees may determine; or without closing the transfer books the Trustees may fix a date not more than 60 days prior to the date of any meeting of the Unitholders or other action as a record date for the determination of Unitholders entitled to receive notice of and to vote at such meeting or any adjournment thereof or to be treated as Unitholders of record for purposes of such other action, and any Unitholder who was a Unitholder at the time so fixed shall be entitled to receive notice of and vote at such meeting or any adjournment thereof, even though he has since that date disposed of his Units, and no Unitholder becoming such after that date shall be entitled to receive notice of and vote at such meeting or any adjournment thereof or to be treated as a Unitholder of record for purposes of such other action. If, in the case of any meeting of Unitholders, no record date with respect to voting has been fixed by the Trustees, the record date for voting shall be 5:00 p.m. on the last business day before the meeting.

Putting a long story short, Slate can decide the voter base between 35 and 60 days before the meeting.

There will potentially be a couple actions taken between now and then, assuming no negotiated settlement.

One is that SOT will conduct a large secondary offering of units. The bought deal will be purchased by Slate-friendly entities.

Two is that SOT will take SOT.DB and post a notice of redemption and declare that the debentures will be converted for units rather than cash. The manner they can do this is described in the indenture (it is the VWAP of 20 trading days, ending 5 trading days before the redemption date). At current market price this will represent another 6.7 million units or so, minus the actual dilutive impact of the conversion notice itself.

I’ve been through the game of a stressed entity converting debentures for stock (Westernone) and it does not work well for both sides, the equity and debtholders.

I’ve also contemplated G2S2 converting its holding of SOT.DB.B into shares to bolster its vote.

Either scenario does not work well for minority unitholders or the convertible debenture holders.

Indeed, SOT.DB is trading at a YTM of 8.7%, SOT.DB.A is trading at 9.8% and SOT.DB.B is at 9.0%, the latter presumably because there is some equity value with the conversion price being relatively close to the trading unit price.

However, in a dilutive environment, that option value is going to fade.

In other words, I quickly came to the realization there is no way for a financial flea such as myself to “win”.

I dumped the debentures. Fortunately the small position was easily absorbed by the market.

After commissions, the ordeal yielded me a profit of just over a hundred dollars and ended my brief episode of becoming a corporate raider.

I’m going to give Tyler a shout-out here for delving into this as well. His conclusion is somewhat different than mine (perhaps there is some value in SOT.DB.B), and his insight is well worth reading.

But for me, I’m just a spectator now.

Ritchie Bros – how to destroy shareholder value

Ritchie Bros (TSX: RBA) has carved out a monopoly-like niche with regards to their construction equipment auction business. As a result, they’ve received a premium valuation. Indeed, in early November their 2023 estimated P/E was around the 33 level, which puts them well beyond my own investing horizon.

However, last Monday they announced they will be spending US$7.3 billion, with about US$2.3 billion in cash ($1.3 billion in cash and $1 billion in the assumption of debt) to take over IAA, an automobile auction company. The market speaks for what I perceive to be the value of this acquisition:

The excuse given by management is one of accessing other markets, geographical diversification, “synergies”, etc.

You’re exchanging 100% of a monopoly-like business for a 59% residual interest in one, and a 41% interest in a company operating in a market that is very competitive. (NYSE: KAR) is an example of a competitor, but there are many others.

You’re purchasing a company that is inevitably at the peak of the historical earnings cycle, while the press release claims a 13.6x “adjusted EBITDA” transaction value on the trailing 12 months.

You’re leveraging a balance sheet which currently is mildly leveraged (net debt of roughly $200 million if you exclude restricted cash) and injecting $2.3 billion dollars of debt (which will suck out another $150 million or so a year in financing expenses).

Needless to say this acquisition is awful if you’re an RBA shareholder.

Mirion Warrants – Nuclear Insurance

I recently took a position on warrants that trade on Mirion Technologies (NYSE: MIR, warrants trading as MIR.WS). My average entry was under a dollar per warrant.

Nuclear Insurance

There are a small number of companies out there that specifically deal with the nuclear industry and even less that are pure plays. You can invest in generalized engineering companies like Fluor (NYSE: FLR) or GE (NYSE: GE), but they have a lot of non-nuclear operations which dilutes the sector interest to an insignificant level. You can also invest in power generation (e.g. Tokyo Electric, 9501.JP), but power itself is a commodity and you are investing in commodity-like characteristics. Likewise the same can be said for Uranium producers like Cameco (TSX: CCO). There are a handful of firms that can be considered pure plays.

One of the historical pure plays in this sector was a radiation detection company called Landauer (formerly NYSE: LDR), but in 2017 they were taken off the public market via acquisition by Fortive (NYSE: FTV), a very large diversified instrumentation company. Another one that I have written about in the past is BWX Technologies (NYSE: BWXT), which its primary moneymaker is producing nuclear reactors for US Navy vessels, but for various reasons I divested myself of this investment earlier this year.

Mirion is a pure play. It is an aggregation of various products relating to radiation biophysics, including medical imaging and also industrial imaging and the like as it relates to the radiological side of things.

I want to clarify the term nuclear insurance. It is specifically looking for a company that will rise in price dramatically whenever there are threats of nuclear catastrophes, likely due to geopolitical concerns or improper operations of nuclear reactors. To be clear, this is assuming that financial markets will still be functional after such an event – if this is of the scale where you have thousands of nukes thrown across the planet, there will be bigger problems to deal with!

The general theme of this trade is thinking of the biological analogy of what happened with Alpha Pro Tech (TSX: APT), a personal protective equipment manufacturer, during the onset of Covid-19:

This company rose by a factor of about 10x from early January to March 2020 when things got really hot and heavy. I would suspect in a nuclear scenario, Mirion would exhibit a similar price curve and hence the ‘insurance’ as probably every other component in the stock market would evaporate at about the same speed as something at ground zero.

Mirion, the company

This trade would be so much more attractive had the corporate entity had better characteristics, but sadly it does not.

Mirion can be described as a broken SPAC offering, going public in October of 2021. The predecessor name was “GS ACQUISITION HOLDINGS CORP II” and merged into what is Mirion today. It was the typical arrangement, going ‘public’ at $10/share with some warrants. Any investors in the SPAC post-closing (who are these people??) have lost money. As of April 2022, about 40% of the company economically is owned by Goldman Sachs entities. 20% are owned by two other hedge funds. The long-time founder and CEO owns about 2% of the stock. The Goldman entities are actively divesting stock – indeed, the principal officers have a listed occupation as “Goldman Sachs” which is amusing in itself. I’m sure the follow question gets asked at cocktail parties: “What do you do for work?” Answer: “Oh, I’m a Goldman Sachs”.

The corporation has a dual class structure, but the second class of stock does not convey any disproportionate privileges.

I’ve discussed above what the company actually does, and it is not a fly-by-night operation. They have about 2,600 employees, and 75 US patents (which you can search for and contain headlines that are in the relevant domain area).

The big problem is financial. The company has a balance sheet issue, and even worse, they don’t make that much money. Note the market cap of the company at a $6 stock price is about $1.25 billion. They got rightfully slammed after their third quarter report. It was awful.

Looking at their Q3-2022 report, the balance sheet has $58 million in cash and $808 million in debt. The only silver lining on the balance sheet is that the debt is in the form of a floating rate (LIBOR plus 275bps) secured loan that does not mature until October 2028, which is a huge time runway for them to figure things out.

The bad news is that the company is cash flow negative. Management talks about positive “adjusted EBITDA” this and that, but in reality, they are bleeding cash. They need to raise their prices and get their cost structure in line, especially now that LIBOR is rising like a piece of Styrofoam rising from the middle of the ocean.

I will spare the quantitative analysis other than to say that while the TTM price-to-sales is very roughly 2x (with companies such as TDY or FTV at 5x and 4x, respectively), the cash generation situation is just awful. This is not an attractive company using trailing financial metrics.

That said, it is in an industry which is relatively inelastic in terms of consumption preferences – companies that need the product are not going to suddenly defer their purchases. As a result, a general economic recession is not as likely to affect Mirion as it would for some other industrial suppliers.

The warrants

The warrants have a headline expiration date of October 20, 2026 and a strike price of $11.50. This is about 4 years to expiry. They are trading around 95 cents at the moment. I will humble-brag that my last purchased tranche to finish my trade was at 80 cents.

It might appear to be a bad deal considering the common stock is trading at half the price of the warrant strike price.

However, when it comes to warrants, they are not always traded like standardized options.

When reading the fine print of the Mirion Warrants, the most relevant non-standard clause governs the option of the company to exercise the warrants if the common stock trades above US$18/share, which will enable the holder to receive 0.361 shares of MIR at a 10 cent exercise price at expiration:

Mirion also has the right to exercise the warrants above US$10/share and the holders have a month to decide if they want the number of shares in the table or whether to take the warrants the ‘conventional’ way. I do not know any scenario where Mirion would want to force the conversion of warrants, but perhaps one of my readers can enlighten me.

Back to nuclear insurance

If there is a relevant nuclear event, I would anticipate the warrants would appreciate significantly beyond their current trading price. As there is time value remaining on these financial products, I would suspect in the worst case scenario in a couple years that I would be able to get out for moderate losses. Again, this is insurance more than anything else. And heaven forbid, if the company gets its cash flow situation in line and actually starts to learn to how to make profits, the stock will appreciate on its own.

This is a small position, I do not intend to make it larger, and the chance of making a loss is relatively high. I share this research for you.

Cenovus Energy Q3-2022 – quick briefing note

Cenovus (TSX: CVE) reported quarterly results.

The salient detail is that in addition to spending $2.6 billion in share buybacks and dividends, they are able to get net debt down from $9.6 to $5.3 billion for the 9 months. Specifically they have $8.8 billion in debt and $3.5 billion in cash.

They have a framework that gives off half the excess cash flow to buybacks and variable dividends. For Q3 this was allocated 75% to buybacks and 25% to the variable dividend.

In the conference call they alluded to this mix depending on the projected returns on the equity, which suggests a price sensitivity to their stock price.

This is exactly how they should be thinking. There should be a point where they stop buying back shares and instead just give it out in cash. At CAD$28/share, that point is getting pretty close.

They have a stated objective of dumping half their excess cash flow into their framework, and once net debt heads below $4 billion, then it becomes all of their excess cash flow. This should happen by the end of Q4.

While I believe a 100% allocation is not the wisest (they should top it out at 90% and focus on eliminating the debt entirely), given the maturity structure of their outstanding bonds, there is zero term risk in the next decade and a half (with their existing cash balances they can tender out the rest of their debt until 2037).

Once they start distributing 100% of their excess cash flow to dividends and buybacks, Cenovus will effectively function as an income trust of yester-year where you had Penn West and Pengrowth consistently giving out cash distributions. The buyback algorithm should auto-stabalize the stock price. At US$90 oil and refining margins sky-high and with little signs of abatement, Cenovus is on track to generating $8 billion in free cash flow for the year. Very roughly, that is about 14%/year and this is much higher than I can recall the historical income trusts yielding.

Unless if the stock price gets ridiculously high, or if management starts to display capital management that is off-colour (i.e. going on acquisition sprees that do not make sense), this is going to be a core holding for a very long time. It is too expensive to buy and too cheap to sell, so I look forward to collecting the cash distributions where I will try to find a better home for.

Can Teck unload their met coal operation?

Teck (TSX: TECK.A/B) had some interesting news yesterday – they dumped their 21% interest in the Fort Hills oil sands project for $1 billion to Suncor (the majority owner and operator), and they also released their quarterly report.

The Fort Hills project was the black sheep of Teck, primarily because it goes against their “wokeist” image they are trying to project and is clearly not in their strategic mandate to be a lead producer of “low carbon metals” (aren’t all metals non-carbon?). Once the Frontier Oil Sands project was shelved, pretty much the days were numbered for the Fort Hills division.

For Q3, Teck’s share of the project was 37,736 barrels of oil a day, and the consolidated project is 180,000 barrels – not a trivial size.

The project historically has been plagued by operational issues and, in my quick evaluation, the deal is good for both Teck (who wanted to get out) and Suncor (who is likely to consolidate 100% of the project in the near future). The Frontier project might get revived in a future decade when regulatory concerns get alleviated, but I would not hold your breath.

Of note is that both companies (Teck and Suncor) will be taking non-cash accounting losses on the disposition – in Teck’s case, the amount of capital dumped onto the project is less than the amount that they were able to get back from it with this disposition. The impairment charge on the books was $952 million. The conference call transcript indicated there was a ‘small capital loss’ on the transaction.

Teck’s major project in the works is the QB2 copper mine in Chile. One reason why their stock had a tepid response to the quarterly report is because of the usual announcements of delays and construction cost escalation, coupled with a decreased expectation for production in 2023. However, this is yet another sign that one cannot click a few buttons on Amazon and expect a mine to start producing – the scale and scope of these projects is gigantic and this one has taken about 5 years to get going from the “go-ahead” decision to when things will be materially completed. If this decision was pursued today, the costs would likely be even higher (not to mention the regulatory climate would be even worse than it is today).

QB2 is the example of their “low carbon metals” strategy, where apparently they can be dug up from the ground without emitting carbon, but I digress. The “to-go” capital expenditure on QB2 is anticipated to be US$1.5-$1.9 billion from October 1, and once this is completed, Teck will be a free cash flow machine barring some sort of total collapse in the copper market (beyond the 30% drop from half a year ago).

The balance sheet is very well positioned, with $2.6 billion in cash and no major debt maturities until 2030 other than a US$108 million bond due February 2023, which they can easily pay off. As a result, Teck will be in a position to either buy back stock or issue increased dividends later in 2023.

But the focus of this post isn’t about QB2 or Teck’s future prospects, it is about their metallurgical coal operation.

Their met coal operation generated $1.24 billion in gross profits in Q3, and $5.55 billion year-to-date. It is single-handedly the reason why Teck is in such a fortunate financial position to be able to dither on QB2 and not get terribly concerned about it.

However, it flies in the face of their “low carbon metals” strategy and this reminds me of last year’s article which rumoured that Teck was looking at getting rid of, or spinning off their met coal operation.

My question is still the same – who would buy this? It is making so much money that even if you paid 2x annualized gross profits (an incredibly generous low multiple), somebody would still need to cough up $15 billion to buy the operation. This puts pretty much every coal operator out there except for the super-majors (like Glencore) out of the picture.

However, if Teck were to dispose of the coal unit, it would likely be in conjunction with a significant distribution to shareholders – a $15 billion sale would result in roughly a $22/share distribution, assuming a 25% tax rate (the actual tax paid will likely be less since Teck’s cost basis will be considerably higher from the Fording Coal acquisition). At a zero-tax rate, that would be roughly $29/share.

However, a giveaway is the non-answer during the conference call:

Orest Wowkodaw
Analyst, Scotia Capital, Inc.
Hi. Thank you. Jonathan, your number two priority seems to be rebalancing the portfolio to low carbon metals. I’m wondering if that if your strategy there is solely around growing the copper business and i.e. diluting the coal business, or do you see the potential for accelerating that transformation perhaps by either divesting some of the coal business?

Jonathan Price
Chief Executive Officer & Director, Teck Resources Limited
Yeah. Hi, Orest, and thanks for the question. There’s a number of approaches that we’ve been taking to that. The first as you’ve seen overnight is the announced divestments of Fort Hills. Clearly oil sands carbon, an opportunity there to reduce weight in the portfolio through that divestment, something we’re very pleased to have agreed and have gotten away.

Secondly, as you highlight really the key approach for us is the growth around copper with the doubling of copper production as we bring QB2 online next year. And then with the projects I mentioned being new range being San Nicolás being the QB mill expansion all bring more copper units into the portfolio which further swing us towards green metals and away from carbon. As we’ve said before, we’ll always remain very active and thoughtful in reviewing the shape of the portfolio and the composition of our portfolio. But right now those factors I’ve mentioned are the key execution priorities and that’s what the team is focused on. And that’s what we’re gearing up to deliver.

I’m pretty sure reading between the lines that they are, at the minimum, thinking of doing this. But who in their right mind would buy such an operation in a very hostile jurisdiction?