Equity – Page 5

Berkshire / Apple

I rarely write about Uncle Warren, but when he makes moves, he picks them really well. Burlington Northern at $100/share was a stroke of very well-timed genius, and even more for him, I am still amazed by his Apple trade he made between 2017-2018, which was a slow and steady accumulation of a huge stake. Don’t get me wrong, he’s had his fair share of disasters (Airlines pre-Covid, for example), but for the most part his investment successes have massively overshadowed his failures.

Warren Buffett’s final cost base on his Apple shares as reported on December 31, 2018 was $35.30/share (he paid $36.044 billion for 1.021 billion shares, split-adjusted). He sold a hundred million shares by the end of 2020, ending with 907,559,761 shares of Apple at an average of $34.26/share. Prior to today’s announced divestment of 13% of his stake, those shares at $180/share amounted to $163 billion. The unrealized gain that he was sitting was $130 billion. So his 13% liquidation nets him about $21 billion and he can offset the capital losses on his Paramount trade which fizzled.

He still has a stack of $142 billion in Apple stock which, needless to say, is still a lot of capital tied up in a single company. There are competing interests that Buffett is facing – one is that the concentration risk of Apple in the overall Berkshire portfolio is massive. Two is that he does not want to give up on the tax deferral value of the unrealized gain (which is likely why his choice to recapture the losses from Paramount was to diversify out of Apple first before anything else). Three is that Berkshire is facing a lack of reinvestment choices – apparently their cash stack is now up to $188 billion and just the interest alone on this, if invested in 5% short-term government bonds, would be around $9.4 billion dollars annually.

Apple reported a diluted EPS of $3.71/share for the past six months (October 1, 2023 to March 30, 2024). This puts Apple at around a P/E of 25 and I bet you Buffett is looking at the announced additional $110 billion share purchase authorization (making it a total of about $140 billion at the end of March 30, 2024) and will be dumping into it further over time.

While the Apple franchise will continue to make a lot of money, the stock is another matter – I personally think it is about 40% over-valued. The company seems to be very happy to buy back their overpriced shares – they bought back 130 million shares in the past three months at $180 a piece, and this is likely to continue for future quarters – this demand pressure on the stock will keep its value artificially inflated until economic and technological headwinds take it down further.

Slate Office REIT – attention to details

It looks like things are getting heated in the board backroom of Slate Office REIT (TSX: SOT.un). 17 days before the scheduled Annual General Meeting, George Armoyan decided to let loose a proxy solicitation to install two additional directors out of six. If he won, including himself, that would constitute a board of six directors – George himself, two controlled by him, two directors (the co-founders, who are brothers) and an independent.

To take action this late in the game suggests that there was some sort of board decision that pissed him off.

Armoyan controls 17.7% of the units, or 15.1 million units of Slate, which gives him huge sway considering that only 36 million units voted on the resolution to increase the gross book value to debt ratio of 65% earlier this year. When adding the 1,123,880 units that one of the director nominees owns, it’s a near majority. 32 million units voted in the 2023 annual general meeting. It’s quite likely that Armoyan will find at least a million or so disgruntled Slate Office holders to vote in his direction to put him over the top.

Part of the previous vote was a consent to decrease the board size from 8 to 6 trustees, which means there are less people for him to take out. If he is successful, he will effectively have at least a veto on every decision from the board, which is close enough to having control of the entire operation.

I do note, however, when reading the proxy solicitation statement, that it must have been hastily constructed. Witness the following from their proxy solicitation:

On the bottom, “PROTECT YOUR IVESTMENT IN SLATE OFFICE REIT”. Not the greatest look for the professionalism of Morrow Sodali, the firm being engaged to solicit the proxies.

Perhaps they all just need to hold on until after June 25 before going into CCAA – at least when everybody disposes their units for zero, they get 2/3rds and not 1/2 inclusion on the capital loss. To be clear, this was a joke and not a prediction although the last financial statement released by the trust is not looking that good!

The nuclear insurance trade – Mirion

(See previous article: November 4, 2022)

Unfortunately, due to my complete inability to properly read the warrant indenture for Mirion’s public warrants (NYSE: MIR.wt), they have called out their warrants because their common stock satisfied a particular call criteria. Unfortunately I was mislead to believe that they could only call out the warrants when the stock was trading above US$18/share when there was a provision that allowed for a call above US$10/share! Oops!

The announcement has the salient paragraph:

Warrant holders may continue to exercise their warrants to purchase shares of Common Stock until immediately before 5:00 p.m. New York City time on the Redemption Date. Holders may exercise their warrants and receive Common Stock (i) in exchange for a payment in cash of the $11.50 per warrant exercise price, or (ii) on a “cashless” basis in which case the exercising holder will receive a number of shares of Common Stock determined under the Warrant Agreement based on the redemption date and the redemption fair market value, as determined in accordance with the Warrant Agreement. The “fair market value” is based on the average last price per share of Common Stock for the 10 trading days ending on the third trading day prior to the date on which the Notice of Redemption is sent. In accordance with the Warrant Agreement, exercising holders will receive 0.220 of a share of Common Stock for each Warrant surrendered for exercise. If a holder of warrants would, after taking into account all of such holders’ warrants exercised at one time, be entitled to receive a fractional interest in a share of Common Stock, the number of shares of Common Stock the holder is entitled to receive will be rounded down to the nearest whole number of shares.

Given that the stock is trading at about US$10.90/share, there is no way that people would rationally choose to exercise for US$11.50/share. At 0.22 shares per warrant, the break-even price for the $11.50 strike provision would be about $14.70/share. So the warrants, for a month, are effectively trading at 0.22 MIR shares per warrant. They will get delisted on May 17 and if people did not exercise or sell them on the open market by then, they will get cashed out for 10 cents a piece for those too sleepy to take action.

The 0.22 share conversion number came from a result of this table, which applies a premium to an early redemption when the stock is above US$10/share:

The warrants were to expire on October 20, 2026 and hence there are about 30 months remaining.

Anyhow, sadly I had to close off this trade – while my gross incompetence did not result in a loss, I do consider it a completely failed trade for my financial illiteracy.

The reason why this trade is so good for “nuclear insurance” is because of the embedded leverage of the warrants – especially the leverage that would occur if there was a nuclear event of prominence. The stock price would skyrocket and the percentage gain on the warrants would be astronomical. While the common stock is an acceptable way of achieving an “insurance payout”, the cost of capital is a lot higher than going down the warrant route. Essentially you just want to purchase as much out of the money as possible (just like how a life insurance policy is effectively selling a call option on the low probability expiration of your life!). The publicly listed equity options do not sufficiently go out in time and are illiquid so you will have to pay the market maker spread – the November 15, 2024 call options with a strike of 12.5 are trading at bid/ask 0.75/0.85, which is a terrible value compared to the October 2026, 11.5 strike for the warrants that were trading at $1.80-ish just a few days before this announcement. Too bad! This really hurt me.

Modelling commodity companies

I’m not much of a technical analysis guru but here is my depiction of the trendline of Cenovus Energy (TSX: CVE):

Will this go on forever and end the year at $70/share? I wish, but incredibly unlikely unless if we’re heading into Weimar Republic inflation.

Despite this price rise, the company is still relatively cheap from a price to free cash flow metric. You don’t need to have a CFA in order to do some basic financial modelling:

This is from their IR slides and they will be spending $4.8 billion on capital expenditures in 2024. At “Budget”, which is WTI US$75, and US$17 differential to WCS pricing, the company will do roughly $10 billion in operating cash flow, leaving $5.2 billion of it free. They also have a sensitivity of $150 million per US$1 of WTI.

Everything being equal (it is not, but this is a paper napkin modelling exercise), at today’s closing price of WTI at US$86.75, they’re looking at a shade just under $7 billion in free cash flow. It won’t be quite this high in reality, but that puts the company at around 8.5xFCF to EV even at the current price. If you were smart enough to buy it at $20/share back in mid-January, at the price of WTI then (US$72/barrel), your FCF to EV ratio would have been… about 9x.

In other words, the price appreciation is strictly a result of the commodity price improvement, coupled with a very small multiple decline (which the truer computer models out there which algorithmically trade all these fossil fuel companies on a formulaic basis perform).

For the fossil fuel components in my portfolio, I have pretty much given up on any other smaller companies other than the big three (CNQ, CVE and SU) simply because I have little in the way of competitive advantage to determine which one of the smaller companies have better on-the-ground operations and superior geographies to work with. They all trade off of the commodity curve one way or another. The “big three” are low cost producers and will generate some amount of cash going forward, barring a Covid-style catastrophic environment.

They are basically the equivalent of income trusts at the moment. Remember the old Canadian Oil Sands (formerly TSX: COS.un) before it was absorbed into Suncor? That’s exactly that these three companies are – they all have gigantic reserves and very well established low-cost operations, and capital allocation that is simply going to dump cash out to dividends or share buybacks.

Risks inherent with all three:
1. A common regulatory/governmental risk being located in Canada, and mostly Albertan operations.
2. Fossil fuels may be subject to displacement if we actually see some sort of renaissance on nuclear power (there are whiffs of it here and there, but going from speculation to reality is another matter entirely).
3. The usual cyclical supply/demand factors.

With point #3, I see in the presentation decks of most of these companies (especially the smaller ones) that they are very intent on increasing production. Despite the fact that TMX is going to be operational in a month, the egress situation out of Canada will once again saturate. No more refineries are being built and thus the demand-supply variable will likely push WTI-WCS differentials higher at some point in the near future. With balance sheets of all the companies stronger than they ever have been, there will likely be some “race to the bottom” effect coming in due course, similar to how the domestic natural gas market has been saturated – both AECO and Henry Hub commodity pricing are quite low and LNG export pricing is back to its historical levels (around US$9.50/mmBtu spot).

I think what will happen is that the higher capitalization companies will use their relatively stronger balance sheets to pick away at the entrails of the smaller, higher leveraged operations when the price environment goes sour. Given the overall under-leveraged bent most of these smaller companies have been taking as of late, this process going to take awhile and a lower commodity price environment to achieve. These are not “forever hold” companies, but certainly at present their valuations continue to look cheap.

Melcor REIT – another cutting distributions to zero

Melcor REIT (TSX: MR.UN) is a small REIT containing 38 properties that is controlled by parent Melcor (TSX: MRD). The book value of assets are $700 million, debt about $420 million and about $12 million in cash flow from operations each in the past couple years. At 13 million units outstanding and at $3/unit, I will leave it up to you to calculate the market capitalization and relative size of this trust to others.

On March 5, 2024 they announced their year-end results. While the actual results were tepid, the big news was the trust finally reduced its distribution to zero citing financial flexibility.

Putting a long story short, they are hitting a debt wall as outlined by one of their significant holders, FC Capital in a letter that came public on March 13.

I won’t delve too deeply into this other than that we have a couple themes in action with this and Slate Office and other marginal REITs:

1. Debt maturities are killing equity value
2. The valuation of illiquid private equity (or in this case illiquid property holdings which is almost as bad) on balance sheets is highly suspicious when it comes to the time that you actually need to liquidate said properties.

You’ve got Allied (AP.UN), Dream Office (D.UN), Artis (AX.UN), H&R, etc, etc., all trading at wildly deep discounts to book value. The financial engineering solution is to liquidate the assets at their stated value and watch the magic happen, right? If it only were that simple!

Just wait until the CPP and other pensions that are heavy on “private” or otherwise illiquidly-valued assets finally get their day in the valuation sun.

In the meantime, the REITs appear to be a reasonable canary in the coal mine, begging central banks for supplemental oxygen.