Equity – Page 14

Signs that you should be looking for a different CFO

Does anybody read financial statements anymore, or do they just let the automated financial data scraping services compute all the ratios for you automatically?

You might think the mix-up regarding the date formatting was a one-shot thing, but no, it is also on the income statement, equity statement, cash flow statement, and notes 3, 4, 11 and 14.

If the CFO isn’t even reading these financial statements, what makes an investor think the company is being run in good hands?

This is another example of what happens when people become overly reliant on push-button systems – eventually two things get lost – one is how the push-button machine works, and the other is the reason why we have to push the button in the first place.

I have caught on occasion some pretty bad typos or formatting errors in financial statements but never have I seen such a blatant presentation error on dates as this one.

Xebec Adsorption – Bankruptcy and CCAA

Words you never want to hear if you’re an equity holder:

Xebec Adsorption Inc. (TSX: XBC) (“Xebec” or the “Corporation”), a global provider of sustainable gas solutions, announces that it will file today an application with the Superior Court of Québec (the “Court”) for an initial order (the “Initial Order”) under the Companies’ Creditors Arrangement Act (the “CCAA”) and seek recognition of the Initial Order in the United States under Chapter 15 of the Bankruptcy Code.

Since Xebec isn’t exactly a household name, here is a description of the business:

Xebec Adsorption Inc. (“Xebec” or the “Company”) is a global provider of clean energy solutions and specialized in the design and manufacture of cost-effective and environmentally responsible purification, separation, dehydration and filtration equipment for gases and compressed air. Xebec’s main product lines are biogas upgrading systems for the purification of biogas from agricultural digesters, landfill sites and waste water treatment plants; natural gas dryers for natural gas refuelling stations; associated gas purification systems which enable diesel displacement on drilling sites; hydrogen purification and generation systems for fuel cell and industrial applications; on-site oxygen and nitrogen generators for industrial, energy and healthcare applications; and services for compressed air and gas businesses.

Since the beginning of 2021, the stock chart does not look pretty:

At its final demise, the company had 155 million shares outstanding, which means at 51 cents per share, it still had a market cap of about 79 million.

Financially, the company was bleeding cash this year and they had blew a covenant on their credit facility (their total liabilities to tangible net worth ratio was exceeded) and thus people reading financial statements would have had some sort of hint this would happen. Goodwill and intangibles amounted to $237 million on their balance sheet, while total equity was $260 million and needless to say the $42 million in net losses for the half year tipped the balance.

It is not a complete loss, however – they have $50 million of cash and restricted cash on the balance sheet, offset by $85 million in debt. While their business is awful (gross margins were less than 10% of revenues in the first half, while SG&A was about 40%!), balance sheet-wise it is not a huge train wreck. Perhaps after restructuring they might make a better go of it, but I doubt equity holders will get any recovery from this one.

While the increasing interest rate environment will likely contribute to further CCAA and bankruptcy filings in the future, in the case of XBC, this one looks to be entirely by self-inflicted wounds. The business isn’t profitable.

I did not own any shares at any time.

Aimia – not at this time

It’s been quite some time (four years) since I’ve written about Aimia (TSX: AIM).

The corporation is much ‘cleaner’ than it was when they were operating Aeroplan and especially now that they’ve sold their last loyalty program (PLM) they are sitting on a bunch of cash and assets. The PLM sale netted about $537 million, and by virtue of significant operating and capital losses in the past, the tax hit on this transaction will be relatively low. They still have a tax shield going forward and one of their stated intentions is to use their newly found half-billion dollars for investments to chip away at their tax shield.

From the June 30, 2022 balance sheet, they have a bunch of investments in income-losing entities. It does not inspire much confidence about future speculations.

Writing off the entirety of their investment portfolio, this leaves them with about $550 million to play with on 92 million shares outstanding, or about $6/share. There is no material liabilities or debt on the sheets. However, they do have $236 million in perpetual preferred shares outstanding which sucks out nearly $13 million/year out of the company, plus an even nastier Part VI.1 tax for another $5.1 million (hint to Aimia management – you perhaps might wish to NCIB the preferred shares). The rate resets are due in March 2024 and 2025, which would be at rates significantly higher than what they are paying now.

We know through public filings that they bought back 7.13 million common shares for $31.45 million in July and August. In a few days we will know about their September buybacks. The ending balance for August would be 85 million shares outstanding and approximately $510 million cash on the balance sheet, minus whatever else they threw money at in the interim.

Practically speaking, Aimia is trading at a price that is close to its cash balance, and assuming the remainder of its investment portfolio is worthless.

You would think that they should be able to convert half a billion dollars into something that earns a positive return. The Divestor Oil and Gas Index would be one avenue.

I tend to shy away from these “sum of the parts” entities because the incentives are generally misaligned for minority shareholders to make a proper return. Aberdeen International (TSX: AAB) was a poster child for this.

Aimia is controlled by Mittleman Investment Management, although they do not own a dominating stake in the company (approximately 10 million shares held between the company and the two brothers). Since Aimia does not have a common stock dividend, returns would be through capital appreciation. This typically would be driven by a share buyback, but as clearly evidenced by July and August’s trading action, the market has been more than happy to part ways with its shares at an average of $4.41.

The preferred shares are also not trading at a level that I would consider sufficient compensation (roughly 7% current yields and illiquid) given the overall situation.

Given the stress we are seeing in the market, even if there was a dump of liquidity on Aimia, I would find it probable that there would be some other part of the market that has a viable operating entity to be trading at equally or better levels at such a time. The fixed income component of it, however, I will continue keeping on eye on.

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.