Equity – Page 24

Bitcoins taking a hit

Today was the first day since the Coronacrisis where Bitcoin took a huge dive:

Speculating on reasons, I’ll offer three potential factors (it is likely a blend of these and other hidden factors):

1. US Thanksgiving resulted in all the automatic buying (ETFs and the like) taking a vacation, resulting in a demand drop and thus price correction.

2. A typical market reaction that occurs when things rocket up continuously for about two months – you get plenty of long players (FOMO!) and a lot of them decide at once to suddenly cash in their chips. Subsequently you get supply dumps of everybody’s trailing stops getting hit which causes a mini-cascade as we have seen. Happens with momentum stocks as well.

3. Speculation that the US Treasury Secretary will make privately held bitcoin wallets illegal. Most people own bitcoins through intermediaries (mainly crypto exchanges), but remember that the whole origin of bitcoin was to decentralize monetary policy. It is a myth that Bitcoin is anonymous – rather it is completely the opposite, with all transactions completely transparent for all to see. The blockchain database is just over 300 gigabytes at present and is available for anybody to download. The bitcoin wallet addresses don’t have peoples’ names on them, but presumably there will eventually be an association made unless if the transactions are done very carefully (i.e. with two parties that aren’t caught up in the usual electronic monitoring sweeps of large value transactions).

Transactions in bitcoins are also internalized off the blockchain and batched until some point where it is economical to post them on the chain itself. This is what practically happens as transactions cost about US$5 to post. This will get more and more expensive over time.

There are a couple analogies I can think of to the speculation of outlawing Bitcoin private wallets: Forbidding people to own (paper) cash without it being deposited into a bank, or forbidding people to own gold. These two were functionally the same thing since when (large scale) gold ownership was forbidden in 1933, US dollars were directly interconvertible into gold at US$20.67/troy ounce.

Another analogy is the pervasive usage of free web-based email providers and communication privacy. Even if you use an external email service, if you communicate with any individuals on a standard (obviously subject to government monitoring) web-based email services, your communication is going to be compromised by virtue of one side of the communication chain being monitored. Essentially the US Treasury is trying to forbid email communications between any individuals that do not use one of the sanctioned services.

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Finally, it is well known that Microstrategy (Nasdaq: MSTR) adopted a treasury policy of holding bitcoins and their CEO gave an interview on CNBC today. The narrative is fairly well known, but at around 1:30 in the interview, the following words were said:

“What they don’t understand is bitcoin is a monetary network. And as a monetary network it is capable of storing and channeling energy over time without power loss.”

The words “storing and channeling energy over time without power loss” triggered my physics background on perpetual motion machines.

Indeed, crypto currency networks are huge consumers of energy. The amount of power being dumped into semiconductors keeping the bitcoin transaction network alive is very high. I’m not saying this is a good or bad thing (there are many other uses of electric power which are wasteful), but Bitcoin is structurally designed to incentivize more and more consumption (the larger the share you have of the network, the higher the chance you have of mining a block of bitcoin, or confirming a transaction for a fee) and hence one of the fundamental limitations of bitcoin will be how much silicon and electricity can be thrown into what (I claim) is the monetary equivalent of stacking one pile of rocks into a corner and then moving them to the other side of the room, repeated many times over.

Since cooling costs are one of the major costs of running a data centre, will it be a structural competitive advantage if you operate your data centre in a country that has very low average temperatures (can use outdoor air ventilation for cooling), coupled with being next to your own privately held nuclear reactor? Siberia anybody?

Melcor / Melcor REIT / Firm Capital

Looks like another dust-up happening in the Canadian REIT market. First we have the ongoing saga at Artis (TSX: AX.UN), but now Firm Capital (TSX: FC) is launching a salvo against Melcor REIT (TSX: MR.UN).

Considering that 55% of Melcor REIT is owned by Melcor (TSX: MRD), clearly Firm Capital won’t be trying to overthrow the board of trustees. However, they can threaten to make things very expensive:

If an oppression action was brought against MDL, MDL would be required to either purchase minority unitholders equity at fair market value or have the business sold accordingly.

The summary of Firm Capital’s argument is that the REIT has an NAV of about $9, while the market value is at $4. Melcor has it at NAV on their books, and is economically extracting far more than it should be, so therefore, the solution is to buy out the 45% it doesn’t own for a small fraction under NAV. Simple!

Firm Capital, in its letter, points out precisely the reason why I don’t invest in the equity of these majority-owned REITs that are spun off from the parent corporation – related party fees tend to put the minority in an unfavorable position. Another obvious corporation/REIT combo is Morguard (TSX: MRC), Morguard REIT (TSX: MRT.UN) and North American Residential (TSX: MRG.UN), where the terms of engagement are set by the parent corporation.

Within the capital structure of Melcor REIT, the convertible debentures are another story. As long as you get paid out in the end, it doesn’t matter if management has their hands excessively in the cookie jar, unless you paid excessively for the call option value of the equity conversion component. Fortunately, in Melcor REIT’s case, when I purchased my debt, they were so far out of the money that it wasn’t something I was banking on. The ultimate irony is that I was getting paid a higher coupon than the REIT units, yet having the security of a debt investment – isn’t safe yield what you’re supposed to be investing in a REIT for?

This soap opera was made even better with Melcor’s response, which included:

Melcor REIT confirms that the first it has been made aware of the November 4th , 2020 letter from Firm Capital was today.

And a few hours later, they went to clarify:

Further to our press release from earlier today, we have investigated the matter and discovered that the original letter, dated November 4, 2020 and sent to us via email by FC Private Equity Realty Management Corp. (Firm Capital), was caught in our spam filter and did not reach any of its intended recipients.

Caught in the spam filter! One wonders if they received any other solicitations that ended up in the spam bucket as well. A tough claim to believe.

I am loaded with plenty of microwave popcorn to watch this debacle unfold.

Canadian Energy Update

Here is a quick post on the state of Canadian energy production companies – especially as the federal government continues to destroy the industry. As of September 30, 2020 there are 12 companies listed on the TSX that are over a billion dollars in market capitalization. There are 24 between $100 million and $1 billion, and some of these names are in very bad shape indeed. Also out of these 36 companies, some are TSX listed but have the majority of their operations outside of Canada.

For this post, I will focus on those above $1 billion. Companies that are under this threshold are still invest-able but one has to pay careful attention to whether they will survive or not in the hostile regulatory environment.

If your central thesis is that fossil fuels are going to decline and die in a relatively short time-frame (e.g. 20 years) then you probably won’t want to invest in any of these. Demand destruction will impair pricing and the ability to produce supply will not accrue excess gains to any names.

However, this is not going to be the case from a simple perspective of energy physics (laws of thermodynamics if anybody is interested in studying). Renewable sources do not scale to the magnitudes necessary. It also costs massive amount of up-front investment to implement renewable energy sources. It is relatively easy to ramp up energy usage from 0% to 5%, but above this, it becomes very obvious what the deficiencies are of renewable power sources (California discovered this in the summer). Putting a long story short, the more renewable (intermittent) sources you have on a grid, the better will be for on-demand generation sources – this means either you go with natural gas (fossil fuel!) or hydroelectric (we’re mostly tapped out in North America). Batteries make sense in smaller scale operations but not in state-province level grids. Or you can rely on imports, which just like liquidity during a stock market crash, is generally very expensive or not even there when you need it the most.

With respect to transport fuels, we will classify this as passenger, freight and aviation. For passenger vehicles, we all see Teslas and the like on the road, but the infrastructure required to refine and produce the battery materials to replace a substantial portion of the automobile fleet is still a long ways away. For freight, battery-powered transport automobiles are an illusion due to the requirements of existing freight haulers (you need to be able to transport 80,000 pounds of goods at a long distance and also cannot afford to spend 12 hours at a charging station to refuel).

My opinion will change if nuclear becomes a viable option again for power generation (from a political and cost perspective, not a technical perspective).

Some pithy notes (these are the C$1B+ market cap companies):
SU, CNQ – Clearly will survive and represent playing a very long game. Personally like these much more than the big majors (e.g. XOM, CHV, COP, BP, etc.).
IMO – Majority foreign (US) held (XOM), wonder if they will make an exit
CVE – The best pure-play SAGD oil sands player (maybe to be contaminated by HSE acquisition)
TOU – Spun off another sub, largest of the Canadian NG players, FCF positive
HSE – Soon to be bought by CVE – will be interesting to see how CVE makes more efficient
OVV – Mostly American now, with big major style culture and cost structure (i.e. $$$)
ARX – Second NG/NGL play, FCF positive
PXT – Substantively all Colombia operations, that said their financial profile is quite good relative to price
PSK – Royalty Corp (royalties are not my thing – just buy the futures, although pay attention to price, if they get cheap enough, royalties are typically a better buy)
CNU – Chinese held, illiquid security
VII – Liquids-heavy gasser, FCF positive (barely), a bit debt-heavy

Chemtrade Logistics, or yield investors be very careful

If any of you hold units in Chemtrade Logistics (TSX: CHE.UN), it is quite possible in the mid-term future that the current $0.05/unit per month distribution (which was already reduced from $0.10/unit per month during the Covid crisis) will be chopped down by about a half. It’s not a guarantee that this will happen.

Chemtrade’s underlying businesses are profitable, but the amount of financial leverage they have accumulated over the years is impressively high. Back many years ago, they were trading in the upper teens despite having an effective payout ratio higher than their free cash flow generation. Although the business itself is relatively stable (it is a staple commodity producer of industrial chemicals that are foundational in nature for many industries, similar to Methanex (TSX: MX)), the leverage is probably going to be too high for the banks to get comfortable with extending credit. CHE did receive a relaxation on covenants until 2022, which will give them a couple years to get their financial leverage metrics in the right direction.

In September, they did manage to close the deal on some additional unsecured debt financing (TSX: CHE.DB.F), but it came at a higher cost – a coupon of 8.5% and conversion price of $7.35/unit, when previous issues (when the units were trading at $20/unit) were around 5% coupons and $25-30/unit conversion prices. Needless to say these debentures are well out of the money. The proceeds of the new unsecured convertible debt was used to redeem the near maturity unsecured debt that was set to mature in June 2021.

The total debt is about CAD$812 million in senior bank debt, and CAD$531 million in unsecured convertible debentures, for a total of $1.34 billion in debt capitalization. Looking at the first nine months of this year (which is not typical due to Covid, but reflects the existing reality), after interest expenses and lease payments, the company generated roughly $85 million in cash. A good chunk of this (CAD$55 million) went out the door in unitholder distributions. There’s a couple scenarios that are possible, but the easiest route is to slowly reduce debt by reducing or eliminating the distributions. The unit price will most certainly take a short-term hit, but as the company’s credit profile improves, the equity pricing (currently at a market cap of roughly CAD$450 million) looks cheap, although it is this way right now because of the high magnitude of leverage.

If there is another credit crisis (whether it is induced by the company’s actions or not) that comes along in the next year, you can be sure these units will be cratering, even further than they have already.

I remember people pumping this income trust around $15-$20, citing the high distribution yield. Right now, I don’t see a lot of pumping, and if they do cut distributions again to get the bank debt down, I’ll be closely examining the equity. I do have a small position in one of their debentures.

A pending restructuring – Peabody Energy

I alluded to, but didn’t name Peabody Energy (NYSE: BTU) as the victim in my August 10 post about a pending debt restructuring. Peabody Energy is in one of the most hated sectors, coal mining. They operate thermal and metallurgical mines in Australia, and a large thermal mine in the USA (in the Powder River Basin, Wyoming) which had its own drama with the Federal Trade Commission that I won’t get into the details. Essentially, the plan was to form a 70/30 joint venture with Arch Resources (NYSE: ARCH) to synergize a huge amount of cost savings on their (very cash profitable) thermal coal mining operation. The FTC rejected it, citing anti-trust.

My timing for the exit of Peabody’s 2022 debt was quite poor as in the prevailing 2 months after the post, the debt traded some 30% higher, but I was generally not cognizant of the state of the market (there was quite a bit of speculation embedded in the lead-up to the Powder River Basin decision which I thought was already baked into the bond price, but clearly it was not).

In their last 10-Q, Peabody ramped up the language to state:

While the Company was compliant with the restrictions and covenants under its debt agreements at September 30, 2020, noncompliance with the first lien leverage ratio covenant under the Company’s Credit Agreement (as defined in Note 12. “Long-term Debt”) is probable as of December 31, 2020, if the Company does not successfully take mitigating actions.

But what was really interesting and fascinating from a debt renegotiation perspective is the 8-K that was released which gave a fairly detailed status of the negotiations with the secured creditors, including the 2022 noteholders. Peabody wants to negotiate an extension, but the parties are far, far off (the least of which is that the noteholders want 12%, while Peabody is willing to go up to 7.125%).

Discussion Materials / November 1 resolution / November 4 resolution

I know the last thing you want to do is probably look at more slide decks, but considering that the public rarely gets to see these backroom negotiations, for those finance folks out there, you’ll get a big kick from it.

I do notice today that Interactive Brokers is no longer showing any quotes for the debt. Yesterday the closing quote was bid 36.45 and ask 46, with the last trade being $200k traded at 37. Illiquidity is one of the reasons why I dumped as quickly as I did – you never know when the rug will get pulled from underneath.

Finally – this company violates Sacha’s investing rules on ticker symbols, which is the following: If the ticker symbol has no resemblance to the company’s name, don’t invest.