Equity – Page 51

Investment companies, agency, and Difference Capital / MOGO Merger

Most corporations that specialize in maintaining equity portfolios typically trade less than their component parts, simply due to the control issue. Shareholders generally have little control or say on when the company can reach their purported net asset values. Management usually has an incentive to not sell off their companies so they can collect salaries and/or benefits and/or power that comes with control.

As a result, it is a very relevant consideration before investing in such vehicles that the incentives of management are in line with your incentives (presumably as a minority shareholder). Some managements do care about their overall shareholder base (Berkshire presently I would judge to be part of this category, although they are much more of an operating company than most think), while most generally regard minority holders as an annoyance to be mitigated. It is rare where minority shareholder groups will organize to a point where a credible proxy fight can be contested, but such contests are expensive and usually the bias is toward incumbent management. A good example of a failed proxy fight was the contest for Aberdeen International (TSX: AAB) in early 2015 (a very brief legal summary is here).

Aberdeen was a notable case where it was trading far below its net asset value and the share structure did not have super-voting shares. The dissident group failed to accumulate enough support and shares to overthrow the board. Aberdeen at that time was trading at 15 cents a share and the book value was roughly 40 cents. Today they are down to a market value of 5 cents per share.

There are plenty of other cases to examine with these types of companies. Dundee Corporation (TSX: DC.A) is a conglomerate with consolidated and non-consolidated investments and has been trading below book value for a considerable period of time. In their last annual report, I highlight the salient page which shows that their operating entities are not doing too well:

Dundee is a dual class structure, with the founding family controlling the entity via super-voting shares. In order to resolve a situation with a redeemable preferred share issuance (which I have written about in the past) they also notably diluted their shareholders – issuing about 42 million shares to go from 61 million to approximately 103 million shares outstanding effectively – at a conversion price of $2/share. After this conversion, the parent company will hold no material debts and management will have a lot more time to be able to figure out how to transform the operating businesses into profitable entities. Presumably until this happens, Dundee will be trading under book value.

The last entity I will point out is Difference Capital (TSX: DCF). They were notable with having “Dragon’s Den” titan Michael Wekerle being their original CEO and lead investor and they invested in a whole smattering of private placements and various business ventures.

This didn’t quite work out for them for the majority of their history. In 2018, they able to focus on monetization of their portfolio in order to mostly pay off a convertible debenture. The remaining part was financed with a 12% secured loan which was partly paid for by insider money. In their year-end of 2018, they held a net asset value of $7.20/share on their financial statements and this was contrasted with a $3 share price (indeed, shortly after the new year, they executed on an asset disposal that spiked their share price up to $4) – hardly a risk for insiders to take when they were first in line on security and taking a nearly guaranteed 12% return – the shareholders are the ones effectively paying for this.

The final monetization of their company was announced on April 15th – however, it was to another company called MOGO Finance Technology (TSX: MOGO) which is chaired by Wekerle and 22.4% of MOGO is already owned by DCF.

DCF is nearly majority controlled by Wekerle (47% via a holding company that he wholly owns). Thus, a DCF shareholder has to ask whether their interests are aligned with his.

The agency issue is whether DCF minority shareholders benefited from the MOGO transaction. The obvious answer, when looking at the financial situation, is no. It reminds me of what Elon Musk did when he merged SolarCity and Telsa together – SolarCity was about to financially fail, but Musk wanted to fold it into Tesla to avoid the negative attention that such a failure would cause, with Telsa shareholders picking up the bill to deal with the entrails of that transaction.

Instead, this transaction was likely to give MOGO some financial breathing space as they were effectively buying the residential value of DCF’s private equity portfolio and more importantly, cash.

MOGO is bleeding significantly serious amounts of money:

The cash shortfall is significant. Operationally, MOGO is not in terrible shape – they reported an operating income loss of $4 million in 2018. The real deficit in MOGO is the cost of their capital. They have $75 million outstanding on a credit facility, $42 million in non-public debentures (ranging from 10% to 18% interest), and $15 million in 10% convertible debentures (TSX: MOGO.DB). When reading the fine print on the credit facility, the following is the key paragraph (note the underlined):

On September 25, 2017, the Company finalized a new senior secured credit facility of up to $40 million (“Credit Facility – Other” and, together with the Credit Facility – Liquid), which was used to repay and replace Mogo’s previous $30 million entered into on February 24, 2014 (“Credit Facility – ST”). This transaction resulted in the extinguishment of the Credit Facility – ST. On December 18, 2018, the Company increased the borrowing limit on the Credit Facility – Other from $40 million to $50 million. The facility bears interest at a variable rate of LIBOR plus 12.50% (with a LIBOR floor of 2.00%) up to the first $40 million of borrowing, a decrease from the variable rate of LIBOR plus 13.00% (with a LIBOR floor of 2.00%) under the Credit Facility – ST. The incremental portion of facility borrowings above $40 million bears interest at a variable rate of LIBOR plus 11.00% (with a LIBOR floor of 2.00%). Consistent with the previous facility, there is a 0.33% fee on the available but undrawn portion of the $50 million facility. The Credit Facility – Other matures on July 2, 2020, compared to the maturity date of July 2, 2018 under the previous facility. The amount drawn on the new facility as at December 31, 2018 was $44.3 million (December 31, 2017 – $28.8 million) with unamortized deferred financing costs of $0.2 million (December 31, 2017 – $0.2 million) netted against the amount owing.

You’re not going to get rich borrowing money at LIBOR plus 12.5%! Indeed, as a percentage of revenues, interest expenses are 28% – they will never show a profit at that level of interest bite.

Hence the presumed justification for the merger with DCF – Michael Wekerle has invested significant resources into MOGO. MOGO is borrowing money at exorbitant rates and DCF will add some assets to MOGO’s balance sheet, which can eventually be liquidated for desperately needed cash.

Does this in any way benefit non-controlling shareholders of DCF? Not at all. This explains why DCF traded down after the transaction and MOGO traded up.

Currently, MOGO has a market capitalization of $80 million (this is after it received a good 15% rise after the DCF announcement). Will they be able to find cheaper financing? Most of their debt matures in 2020.

But either way – this is yet another example of making sure to check the motivations of controlling shareholders before you jump on board – you might find they will make decisions that will have little to do with adding value to the stock and instead use the entity for other strategic purposes.

Bellatrix Exploration recapitalization

The carnage in the small-to-mid cap Canadian oil and gas sector continues.

Today’s interesting news is the recapitalization proposal of Bellatrix Exploration (TSX: BXE).

In this process, I’ll walk through the financial statements and this will give you a snapshot of how I go through these things. Indeed, this is not exhaustive, but a small part of the thought process.

Readers with exceptionally good long-term memory will know that I had an investment in their debt a very long time ago. Indeed, you can read about a minor exit trading error I made on the investment.

I haven’t touched Bellatrix since (9 years ago!), but still keep track of things. You never know when future opportunity may strike.

Bellatrix, just like most smaller Canadian oil and gas companies, has been really struggling.

From the cash flow statement:

The key 2018 figures include CAD$52 million in EBITDA (not including impact of hedging), but the “I” is $41 million (cash cost is $35) and the “DA” is about $70 million of capital expenditures. People that are untrained at reading financial statements of oil and gas companies will be swayed by the syren’s voice of operating cash flows without due regard in consideration to how much capital expenditure it actually takes to sustain those barrels of oil (equivalent) per day.

In other words, the entity bled about $54 million cash in 2018. Without a change in oil price, the company is going nowhere financially.

On the balance sheet, we note that the company has no cash on hand (cash is provided by a credit facility) and is capitalized by debt financing. This next picture is a gong-show illustration, so forgive me:

This is a company that is in very bad shape on its balance sheet. People that look strictly at financial metrics will see a $672 million book value (shareholder’s equity) and they will say “Hey! That’s over $8/share in value, and with the stock trading at 50 cents that’s a bargain!” but in economic reality, most of that equity value consists of already spent money that takes place in the form of Property, Plant and Equipment – exploration expenses that are capitalized and not expensed. Whether these assets have any recovery value or not depends on economic assumptions of the price of fossil fuels.

The company also has germane issues with its solvency – so we have to dig into the credit facility and debt financing:

We discover the company can borrow up to CAD$95 million and that this facility is first in line, and is up for redetermination at the end of May. This is not a good sign.

The next in line to maturity are the senior notes (which are third ranking, US$145.8 million par outstanding) and this matures in May 15, 2020 (not that far away). The first and second in line creditors will not allow a third-line creditor to jump them in maturity, so this has the makings of a classic credit crunch, which has to be solved. One scenario is that the credit facility provider will choose to extend the timeline another six months to facilitate a recapitalization, but in no way would they ever allow the senior notes to be repaid without huge assurances they would be paid first. Note the second-line noteholders do not have the ability to directly compel BXE to not pay the Senior Notes, but there are covenant issues regarding the loaning of money that is adverse to the interests of the second-line noteholders.

There are other issues regarding covenants which I will ignore for the purposes of this analysis (this adds a layer of complexity which in itself is interesting but I don’t wish to get into this post).

Now we get to the meat of the recapitalization proposal:

* an exchange of all of the Company’s outstanding 8.5% senior unsecured notes due 2020 (the “Senior Unsecured Notes”) for, in the aggregate and taking into account early consent consideration, a combination of US$50 million of new second lien notes due September 2023 (the “New Second Lien Notes”), US$50 million of new third lien notes due December 2023 (the “New Third Lien Notes”) and approximately 51% of the common shares of Bellatrix outstanding immediately following the implementation of the Recapitalization Transaction; and

* an exchange of all of the Company’s outstanding 6.75% convertible debentures due 2021 (the “Convertible Debentures”) for, in the aggregate and taking into account early consent consideration, approximately 32.5% of the common shares of Bellatrix outstanding immediately following the implementation of the Recapitalization Transaction.

…

* it is a condition to completion of the Recapitalization Transaction that the Company’s existing senior bank credit facility (the “Credit Facility”) (which currently matures on November 30, 2019) be extended for a one-year term on terms substantially similar to those currently in place;

The summary is that the company is asking their US$145.8 million senior noteholders to take a US$45.8 million haircut in exchange for 51% of the equity in Bellatrix, and also to become pari-passu (equal standing) to the second-ranking noteholders for US$50 million and effectively extend their own notes for another 3.5 years. The convertible debentures (CAD$50 million par, who are last in line on the pecking order) will receive 32.5% of the equity in Bellatrix.

Existing shareholders will keep 16.5% of the company, in exchange for offloading CAD$50 million plus US$45.8 million in debt, but the company will also receive a term extension on the primary part of its debt until 2023 (when everything becomes due).

The company obtained consent of 90% of the senior note holders (so passage becomes inevitable), but the question then becomes – what if the convertible debenture holders do not agree to this? They received consent from somebody owning 50% of the debentures, but with regards to the other 50%, they cannot be “force consented” unless if a sufficient number of them vote in a class to recapitalize (I am not sure what the threshold amount is).

The debenture holders, if they do not agree, can be told by the company that they will go into CCAA to force the matter (where they will receive nothing in return, instead of the 32.5% equity they are being offered today).

Hence it is interesting that the convertibles are trading up about 10 cents on the dollar today to 60 cents – valuing the remaining equity (plus the encumberance of the second-lien debt and credit facility) at CAD$92 million.

By no means does this recapitalization put Bellatrix on a good financial standing – certainly offloading CAD$111 million in debt will be good for the company, but the underlying operations still need an assist on the price of oil. If this recapitalization does go through, there are still considerable headwinds to be faced.

Pengrowth is hitting the financial wall

Pengrowth Energy (TSX: PGF) is an entity I have been following for a very long time. I used to own their debentures, which matured at par a few years ago. Today, their financial situation is much more dire and from their annual report (released today), we glean the following:

Suffering from low prices and high capital costs, the company is still bleeding money. In addition, when looking at their balance sheet:

This is not a happy situation. Although management is “positive” they can strike a new credit agreement by the end of this month (when their secured credit facility becomes due), every bank in this syndicate will see CAD$59 million going out the window in October and another CAD$128 million going out eight months later. Considering the banks are the senior secured creditors in this arrangement, I very much doubt they will be willing to extend credit to the point where the October 2019 noteholders will be paid.

There is also the issue of the covenant, where the interest coverage ratio for Q4-2019 has to be better than 4.0, while presently (for the 2018 calendar year) such ratio was 1.6 – barring a huge increase in oil prices in the remainder of this calendar year, PGF stands no chance of meeting this covenant, which applies to both bank debt and notes.

PGF is going to have to negotiate immediately with their secured creditors a 6 month extension (which is currently what they disclosed) but during this six month period will have to negotiate with noteholders and the banks alike to come to a consolidated credit agreement. This is not going to be easy. In other words, we have a credit crunch.

The stock took a nose dive from 73 cents down to 51 cents in today’s trading, but has somehow managed to recover to the 74 cent level despite this news, which I found very fascinating.

The only real wildcard in this entire matter is (billionaire and former large Canadian Oil Sands investor that opposed the merger with Suncor) Seymour Schulich’s huge equity stake in the entity, owning about 29% of the company. Will he bail them out before the banks decide to take the entire firm for themselves?

Some utility companies are not so safe

I’ve been following the PG&E (NYSE: PCG) story rather closely.

I don’t know anybody that would actually want to operate a utility in California with the state’s liability regime (you are completely liable for damages as a result of wildfires) and this is a pretty clear example of avoiding an investment that will have a good blow-up disaster potential.

Most publicly traded utility companies trade as if they are stable and boring, but in reality, there are quite a few that have embedded hidden risks – beyond their insurance regimes.

The more interesting part of this story is that even after the initial wildfires to cause the slide in the stock, an investor still had plenty of time to bail out before PCG was finished.

But now they’re into Chapter 11, primarily to shed liabilities associated with the California wildfires.

Financially, PCG has US$20 billion in equity on the balance sheet, which works out to about $38/share. They accrued $2.8 billion in wildfire-related claims in liabilities, but estimates are that there will be about $22 billion coming in, which would nearly wipe out the equity in the company.

The unsecured debt is trading at around 80 cents on the dollar presently, but one could make quite a bit of money on the equity if your loss projections on claims were less than what the market is projecting at the moment.

I’m not the type of person to be playing such types of financial games as there are typically far more smarter people than I am (to determine the residual value of PG&E after claims), but I still find it interesting to see how it will resolve nonetheless.

One thing is for certain – people still need to be supplied electricity, and electricity is a very inelastic commodity. When you have so much state regulation in place, especially when hearing about multi-billion dollar capital and maintenance expenditure proposals to prevent future wildfires across huge amounts of power lines, it all serves to have one effect – raising the cost of electricity for captive customers. California residents (e.g. Los Angeles) already pay very high rates for power – and after this debacle on PG&E, they’ll be paying more after these claims are settled. The money has to come from somewhere.

Think a moment about your investments in well-known utility companies such as Emera (TSX: EMA) or Fortis (TSX: FTS) or Hydro One (TSX: H) for a moment. Is there more risk than you originally anticipated?

S&P/TSX 2019 year-end projections and predictions

Article on the Financial Post of various analysts predicting where the TSX will end up in 2019. Right now it closed at 14,222. I’ve put percentages next to the predictions:

Predictions for TSX at the end of 2019:
Laurentian Bank of Canada — 18,500 points (+30.0%)
BMO Capital Markets — 18,000 points (+26.6%)
National Bank of Canada — 16,600 points (+16.7%)
Russell Investments — 16,000 points (+11.1%)
CIBC — 15,600 points (+9.7%)
Sunlife Global Investments — 15,000 points (+5.5%)

I wish this list was more comprehensive. Sadly after doing a couple minutes of scouring the internet, I could not find a decent list of December 2018 predictions made in December 2017 other than Russell Investments predicted in late 2017 that the TSX would close 2018 at 16,900. I’m sure my readers can find a more appropriate list.

All I can say is the following – the numbers above also are based on a price index. The total return of the TSX includes dividends, and this would increase the stated percentages by approximately 3%. So the worst prediction of the six above would show a total return on the TSX of roughly 8.5%.

The TSX’s total return (dividends reinvested), as measured over the past decade, is approximately a shade over +5% compounded annually. Recall that 10 years ago was in the depths of the financial crisis and was one of the best investing opportunities in a generation.

If I was a broad market investor, I’d be concerned at this degree of bullishness.