Equity – Page 43

Gran Colombia Gold’s confusing capital allocation strategy, part 2

Read “part 1” here. Gran Colombia Gold (TSX: GCM) announced their quarterly results a few days ago.

At September 30, 2019, the cash position was at US$63.2 million. There is another US$5.8 million that goes to the noteholders. Total debt is US$91 million (US$73.6 million in notes due April 2024, CAD$20 million in convertible debentures due April 2024, convertible at CAD$4.75). The leverage situation is better than it has been for these guys for ages.

Cash-wise, in the past 9 months, the company has made US$38.7 million in free cash flow (operating minus expenditures on mines, but not including SSP.TO investments). As long as gold remains at current price levels, they should be able to generate cash along these lines.

Now this is where things get wonky.

From June 12, 2019 through September 30, 2019, the Company purchased a total of 137,100 warrants for cancellation at an average price of CA$2.41 per 2024 Warrant.

The warrants have a strike price of CAD$2.21/share. Ignoring the time value of the warrants (which is not inconsiderable), GCM effectively repurchased stock at CAD$4.62/share. If they repurchased the actual common shares, they would have paid less.

On November 5, 2019, the Company closed a non-brokered private placement (the “Private Placement”) with 2176423 Ontario Ltd., a corporation that is beneficially owned by Eric Sprott. Through the Private Placement, Mr. Sprott acquired 3,260,870 units of the Company at a price of CA$4.60 per unit for a total investment of CA$15 million, the proceeds of which will be used for general working capital and corporate purposes. Each unit consists of one common share and one common share purchase warrant exercisable into a full common share at CA$5.40 per share expiring November 5, 2023.

This is just strange and contradictory capital allocation. A few months after effectively repurchasing stock at $4.62/share, they then sell a bunch of it at $4.60. There was no need to raise CAD$20 million in debentures back in April 2019, and there is no need to raise CAD$15 million in November… unless if they’re planning on blowing a lot of money on everything else. Their common stock would likely be higher today if they had not done so.

The notes are very likely to be called out or mature, while the common stock will be quite sensitive to the price of gold.

One other theory that I have is the following, and this is relating to GCM dumping their selling partners late last year:

As described in Note 11a, in January 2019, the Company terminated its long-term supply agreement related to the sale of its gold and silver production in Colombia. On May 10, 2019, the Company received notice of a request to settle the dispute, as permitted under the supply agreement, under the Rules of Arbitration of the International Chamber of Commerce. In its notice of arbitration, the former customer has requested reinstatement of the supply agreement and damages related to the intervening period since the supply agreement was terminated. In the alternative, the former customer is claiming general damages in the amount of $50 million, or such other amount as may be determined prior to or at the arbitration, punitive and/or exemplary damages of $1 million, repayment of $0.2 million of disputed interest and reimbursement of costs and expenses related to the arbitration. The Company believes as a result of breach of performance by the former customer on numerous occasions that it had a justifiable basis for terminating the supply agreement and will vigorously defend its position in the arbitration proceedings. The Company believes that it is more likely than not that it will not have any liability from arbitration.

If the company has a 49% probability they will have liability (which is “more likely than not it will not”), they might have a justification for assembling a bunch of cash – much better to have it on hand to pay out instead of scrambling into the markets with your hand stretched out!

The end of Temple Hotels

Temple Hotels (TSX: TPH) is finally going to be removed from the public markets for CAD$2.10/share by majority shareholder Morguard (TSX: MRC).

Temple has been the target of a slow motion takeover which, in 2015, was effectively finalized by Morguard by the assumption of its asset management agreement, and repurchase of debt securities. After, they proceeded to raise capital through rights offerings which resulted in Morguard accumulating a 73% stake in the company. An entity associated with Clarke’s (TSX: CKI) Armoyan, owns 17% of Temple and agreed to be bought out by this price.

I said a long time ago I was wondering what the heck Morguard was doing meddling with Temple given Temple’s financial statements – even after injecting a bunch of equity capital, the company still appears to have sub-standard financial metrics. Four years after this slow motion takeover, my thoughts still persist. It’s one reason why I wasn’t exactly looking at the prospect of buying equity at CAD$1.80/pop, which was the trading price it was very thinly trading at for most of this year (heaven forbid if I was forced to participate in another rights offering).

Statement on Brookfield Asset Management and its family of subsidiaries

Too complex. Bruce Flatt is undoubtedly a genius (in John Malone style), but compare Brookfield with the relative simplicity of Berkshire (despite Berkshire controlling a much larger asset base) and there is such a huge night and day difference. My general issue with large conglomerates with lots of partially owned but controlled subsidiaries is that you run into agency issues with the boards having common members, but having to guess which arm of the company is going to be advantaged (or whether it mostly flows to management).

So a long time ago, I excluded Brookfield and its subsidiaries from being investment candidates – too difficult. I’ve always taken a superficial liking to Brookfield Property Partners (TSX: BPY.UN) (their takeover of General Growth was well timed), but even that entity has a snake’s pit of issues relating to structure. There’s a whole bunch of other REITs trading on the TSX (and indeed the NYSE) that give property exposure with a lot less complexity.

The DREAM preferred share comes to an end

Dream Unlimited (TSX: DRM) had a class of preferred share (TSX: DRM.PR.A), which by virtue of their split from Dundee Corp (TSX: DC.A) had an unusual characteristic – it had a par value of $7.16/share, and was redeemable by the company or the shareholder at any time. In the meantime, it paid out a quarterly coupon of 12.53 cents per share, or 7% on par. The company retained an option to redeem the preferred shares for their own stock at 95% of a prior trading range of DRM stock or cash (or a $2 floor).

This preferred share has been trading for quite some time, and by virtue of DRM’s relatively stable balance sheet, was never in threat of suspending its dividend.

As such, yield-hungry investors could use this preferred share as a cash parking vessel. Even better yet, the dividends that were paid were eligible dividends which would qualify for the dividend tax credit in non-registered accounts. Over time, however, DRM.PR.A became over-utilized and started to trade at a significant premium to par:

The peak was on August 31, 2019 when some poor soul paid $7.56/share for this, or a 40 cent per share premium over par value. This investment would have taken over three quarters of dividends in order to pay itself off. Indeed, at this price the current yield would have been 6.63% for a perpetual investment.

All good things, however, come to an end. Today, DREAM Unlimited announced a substantial issuer bid on their common shares and also the following paragraph:

The Company also intends to redeem all of its outstanding First Preference shares, Series 1. As at November 11, 2019, there were 4,005,729 Preference shares, series 1, issued and outstanding. They may be redeemed at the option of Dream, at any time, at a price of $7.16 per share, plus all accrued or unpaid dividends up to but excluding the redemption date.

As such, one of the best cash parking vessels on the TSX will be off the ledgers. I would expect the shares to crash 4% tomorrow in trading. Fortunately I sold the last of my DRM.PR.A in 2018.

To my knowledge, there is only one other financial instrument that trades in a similar manner, which is Birchcliff Energy’s preferred shares (TSX: BIR.PR.C) which are redeemable by the holder as of June 30, 2020. They also give out a 7% coupon. They are also trading above par. Although the premium is very modest at present, when adjusting for the dividend dates it effectively makes these shares at a tiny discount. There is more balance sheet risk with Birchcliff given its spacing in the natural gas industry, hence why it is not trading wildly above par value at present, in addition to a potential share conversion price at a floor of $2/share (Birchcliff common closed at $2.21 today). I’ve held some of these since February 2016.

Corus Entertainment – quick look

Corus Entertainment (TSX: CJR.B) is a well known company. They have various media assets in Canada on television and radio. At one point I was considering a purchase, but held back because they are highly leveraged and I didn’t have a solid grasp on the risk/reward profile – I suspect they do have competitive advantages but the broadcasting industry is shifting so much (“cord-cutting”, Netflix, etc.) it is difficult to tell whether it is sustainable.

Reading their year-end financial statements, there are a few interesting wrinkles which caught my attention.

0. Fiscal year ends August.

1. They historically have generated a lot of cash. FCF in FY2018 was $344 million, and $307 million in 2019. In 2019, they chipped away $250 million on their debt (which stood at a FY year end balance $1,732 million). Most of this debt was issued to facilitate the acquisition of Shaw Media. $258 million is due November 2021, $869 million on May 2023 and $639 million on May 2024. Clearly they won’t stand much of a chance of paying back the 2023 and 2024 tranches, but one would presume if they rake in $300 million a year in free cash, this won’t be a problem to refinance. The effective rate on the debt is 4.3%.

If for whatever reason this future operating cash flow were to drop at a more accelerated pace, however, the equity is going to suffer badly.

But needless to say if one believes that $300 million is the norm, $1.42/share in cash means the Class B shares trade at a 3.5x multiple…

2. The amount of dividends issued is structured in a peculiar manner:

Corus slashed their dividend 80% last year so they can concentrate their capital on deleveraging. However, the amount of dividends going to non-controlling interests is quite high.

The concept of non-controlling interests is not easy to explain in accounting terms, so I will try here.

Let’s pretend you own a holding company, but this company’s only asset is the ownership of 70% of voting and common shares of an operating entity. If the operating entity makes $100 of income, you consolidate the operating company’s financial statements into your own, but $30 of that income is attributable to non-controlling interests. Shareholders of the holding company effectively only “see” 70% of the operating company’s income.

This is most prominent in a case like Interactive Brokers (Nasdaq: IBKR) where a shareholder of IBKR (76.7 million shares outstanding) owns 18.5% of IBG LLC, which is the entity that actually owns most of the assets. In the 3 months ended June 2019, for example, IBG LLC reported $210 million in net income, but $178 million goes to non-controlling interests (the 81.5% that owns IBG LLC, mainly Thomas Petterfy) while IBKR holders effectively see $32 million. Indeed, IBKR holders will only be able to “cash in” if IBG LLC is generous enough to distribute earnings to it (which they do through a nominal dividend, and control is not an issue because the entity has the same controlling shareholders).

Indeed, when we look at Corus’ income statement, we see that various entities contribute a 13.6% slice on net income:

So one obvious question is the following: what is the agreement governing the non-controlling interest and Corus? It appears that the non-controlling interest has favourable agreements with respect to cash distribution than common shareholders. What entitles these non-controlling interests a $30 million slice of income each year when common shareholders get 56% of the dividends paid by Corus?

I haven’t been able to figure this out.

However, on page 51 of their financial statements, we have the list of subsidiaries, and the non-controlling interest must come from these entities:

I never knew the Food Network and HGTV was so profitable!

What sort of agreements are stripping so much value away from common shareholders? I tried looking into the MD&A and AIF, but couldn’t find any relevant answers.

3. Here is the biggest issue I have with Corus – alignment of interests.

Shaw used to own 38% of the non-voting Class B shares of the company (the only shares which are publicly traded). They dumped this stake for CAD$6.80/share on May 31, 2019. However, the Shaw family trust still owns 85% of the Class A voting shares (3,412,392 shares outstanding) which means they have an economic stake in the company of 1.6% but still total control. Now that Shaw is virtually out of Corus, the incentive structure is completely mis-aligned with common shareholders. Right now the 24 cent/year dividend is the only thing they have going for it. One wonders what sort of value-stripping agreements might take place in the future (similar to my suspicions on the relatively high cash drain coming from non-controlling interests – where is this value going?).

It is one thing if the controlling shareholder has a significant economic interest in the firm they are leading (e.g. one would suspect that Genworth Financial is not going to take actions that will hurt the economics of the underlying Genworth MI entity). It is completely another thing if somebody has control but no economic interest – this sort of alignment asks for common shareholders to get the short end of the stick.

If anybody has answers on this one, or if I’m completely out to lunch, I’d like to know.