Category: Equity

Pinetree Capital will undergo a change of control

A company that I used to write about in the past, Pinetree Capital (TSX: PNP), will finally be undergoing a change of control.

I own a small portion of their senior secured debentures (TSX: PNP.DB). This holding was much larger earlier in 2015, but they were mostly liquidated through redemptions throughout 2015. By virtue of the last redemption (which was partially paid out in equity) I also own a small amount of equity in Pinetree Capital that I have not bothered to selling yet as they were trading below my opinion of fair value.

I anticipated that the final liquidation of the public entity would be in the form of a constructive sale of its sizable ($500 million+) capital losses. Instead, it comes in the form of a rights offering. I’m not sure what the formal terminology of this is, but I would call it a passive takeover.

Pinetree will issue rights that are exercisable at 2.5 cents per share (which is about a penny, or nearly 1/3rd, below their existing market price). If no more than 40% of these rights are exercised, then a numbered corporation entity controlled by Peter Tolnai will exercise the remaining unexercised rights and take control of approximately 30-49.9% of the company. Tolnai also receives $250,000 for his efforts (probably paying for a lot of legal and advisory fees to structure the rights offering) (Update: Only $250k received if there was a superior offer, see the comments below).

Considering only 22 million shares (of approximately-then 200 million shares outstanding) were voted in their last annual general meeting, it would be a reasonable bet that investor appetite to purchase further shares in Pinetree will be most certainly less than 40% of the existing shareholders. A 30% stake in the company is akin to effective control. I have some fairly good guesses why Tolnai would not want more than 50% ownership of the company.

The rights will be traded on the TSX, but my analysis would determine the price would trade at bid/ask $0.005/$0.01 assuming the common shares are trading at bid/ask $0.03/$0.035. As a result, the rights would not be easy to liquidate after transaction charges and would probably remain relatively illiquid.

Peter Tolnai, judging by his website, feels like somebody I could relate to personally. My guess is that he is taking a strong minority stake in the company for the purposes of obtaining a functional, inexpensive, and public entity to raise capital and utilizing the rich reserves of capital losses to grow capital tax-free. I would deeply suspect he has a team in mind and will be raising capital after the April 22, 2016 special meeting that will authorize a (much needed) 100:1 reverse split.

The net proceeds of the rights offering is to pay off the senior secured debentures, which mature on May 31, 2016. The amount outstanding on the debentures is not huge – $6.7 million principal plus six months’ interest (another $335,000). However, Pinetree has disclosed in its filings that if it is unable to raise money with these rights, they would have to liquidate its remaining privately held investments, implying it does not have anything liquid anymore.

Considering Pinetree Capital has not released any financial information since the end of their September 30, 2015 quarter, it remains to be seen what their current balance sheet situation looks like on the asset column. I’m guessing they sold off all of their liquid publicly traded securities in 2015 (the largest of which was PTK Technologies). Pinetree must release their audited financial statements for the year ended December 31, 2015 by the end of March.

Shareholders as of March 23, 2016 will receive the rights to buy at 2.5 cents per share (which means March 18, 2016 is the last day to purchase common shares if you wish to receive rights), but somehow I don’t think the market will be bidding up Pinetree common shares.

This leaves the last question of the valuation of the final entity, assuming the rights are exercised in full. With the senior secured debentures paid off, there is likely a non-zero value in the company, but a better snapshot can be obtained after the release of the year-end 2015 statements. Another question will be how Peter Tolnai’s team will plan on making capital gains and utilizing the huge tax assets left in Pinetree, but considering he will likely have a 30-49.9% stake in the company, his incentives are well geared towards the passive shareholder base.

Utilizing Pinetree’s capital losses is actually a problem that I would like to help him solve, to quote a line from his “Giving Back” section on his biography, if I was so privileged!

Re-examination of Yellow Media

I’ve written about Yellow Media (TSX: Y) extensively in the past on this site before their recapitalization.

I’ve been generally surprised at their financial performance – from 2014 to 2015, revenues dropped only 5% and while EBITDA margins have compressed (to around 31% from 36% before special items), the negative trajectory is flattening out rather than an accelerated drop. Notably they’ve been generating a ton of cash relative to their market capitalization – $73 million in 2014 and $122 million in 2015.

Balance sheet-wise, they are still leveraged. After their recapitalization, their senior secured debt holders receive a mandatory redemption payment of 75% of free cash flow. In 2015 they repaid about $100 million of debt and since the recapitalization (December 2012) the total has been $393 million, or nearly half the balance outstanding. It is probable that they will be able to redeem another $100 million in 2016 and by that point it should be evident they will be home free (in addition to paying less onerous financing charges).

They reserve the right to redeem more debt prior to May 31, 2017 for 105%, and afterwards at par value. Thus, it would make sense that the company would be aiming for June 1st for a refinancing of existing debt and a removal of the pesky covenants that have been restricting management’s ability to perform other functions with their capital.

The only other debt outstanding are unsecured debentures (TSX: YPG.DB) of which $107 million remain outstanding. These debentures have a coupon of 8% and mature on November 30, 2022 – quite a long-dated debenture. Only after the senior secured debentures are matured, these debentures can be called by the company at 110% of par anytime, or 100% after May 2021. The company can also choose to defer cash interest payments and accrue a 12% payment-in-kind provision but so far they have not exercised this route.

Another feature of these debentures is that they can be converted to Yellow common shares at $19.04 – which is barely above the existing market price of $18.95 on Friday’s close.

This creates an interesting valuation puzzle. Investors have functionally sold a call at 110% of par to the company contingent on the redemption of the senior secured debt, while they have an embedded call linked to the common share price.

In terms of business valuation, if Yellow Media’s revenue/EBITDA margin trajectory remains roughly what management projects (which amazingly to date has been generally the outcome), Yellow Media should be earning somewhere around $70 million in net income. This would work out to $2.50 per basic share outstanding (not accounting for dilution if the debentures convert). If there is a modest growth valuation assigned to the company, one can make a case that Yellow should be trading around $30/share and not the $19/share it is trading at presently.

This would place a valuation of about 150-160 cents on the dollar for the debentures, with relatively little downside from current market prices (the bid of 109 would go down to somewhere around par if the underlying business eroded faster than the current trajectory).

This also does not account for the time value of the at-the-money call option within the debentures – currently their warrants with a strike of $28.16 (nearly 50% above current market value) and an expiry of December 2022 trades at $4.13, so there is clearly time value in the call option.

The warrants are unattractive because break-even would be a common share price of $36/share (i.e. if you bought warrants at $4.13 vs. common shares at $18.96, you would do equally well with an investment if the common went up to $36/share at expiration – note your warrants would do significantly better if $36/share was reached prior to expiry).

While I am not interested in the common shares or warrants, I did buy a small amount of debentures near par in January with the expectation of holding onto them until they are likely redeemed (or if the common shares trade above $20.94, converted). They are a low risk, medium reward type investment. I will caution anybody wanting to trade them that you should be prepared for a very slow market and part of the reason why I have such a small holding is because of the relative market illiquidity.

Genworth MI

It is quite obvious by trading action over the past month that some institution is accumulating shares of Genworth MI (TSX: MIC) and is sweeping up the supply that is being applied at existing prices. I loaded up in shares during the second half of January and bought a very small position in some out-of-the-money options (the Canadian options market is illiquid, high-spread, expensive to trade in and generally junky, but there was somebody on the ask that was not the market maker and at a reasonable price, I hit his ask). Genworth MI is once again the largest component in my portfolio.

It is difficult to understand how something trading at a greater than 1/3rd discount to tangible book value and giving a greater than 7% cash yield, and trading at a P/E of 8 can continue to trade so low unless if it can be explained by general paranoia (which exists on Canadian housing).

Insiders (as of February 22) have reported purchases of common shares of Genworth MI. They are not huge but it is something.

The reports of the Canadian housing market’s demise is clearly over-blown except in very narrow sectors that have traditionally had resource commodity concentration (looking at Fort McMurray as the prime example).

The underlying entity is incredibly profitable. The only real risk is whether the parent entity (NYSE: GNW) will sell Genworth MI out, which is a real possibility.

Such a sale, if done presently, would likely be done under book (CAD$36.82 presently). A sale at 10% under book ($33.14/share) would still be a 25-30% premium over current trading prices. The company’s P/E would still be 8 at this point and an acquisition would be instantly accretive to some other financial company.

This take-out price does not reflect my true value that the company should be trading at, which I would judge at least at book value. The Canadian economy, and thus residential mortgages servicing abilities, is not the most robust so the premium to book would be modest before I started to sell shares again. I also apply a general discount to majority-controlled entities, but suffice to say my target price is north of CAD$36.28.

Genworth Financial’s issues I do not want to get into in depth, but they have a pending May 22, 2018 debt maturity (bonds are trading at 87 cents on the dollar at the moment) and a series of maturities 2 years later (June 15, 2020, trading at 68 cents) that the market is getting panicky about. This may cause them to sell out their equity holdings in the mortgage insurance firms they have taken public (Canada and Australia), but it is a decision I do not think they would want to make lightly.

Bank of America warrants look expensive relative to common shares

I don’t profess to have a deep understanding of the large American banks, whether we are talking about Citigroup, Wells Fargo or Bank of America. In the case of Citigroup and Bank of America, they are all trading under book value. Wells Fargo undoubtedly has a premium because of the Warren Buffett influence and probably because its balance sheet is cleaner. There are multiple analysts in high-paid jobs that spend their careers understanding these entities and I have no chance on obtaining a competitive edge on them.

I do not have any positions in these stocks nor will I – they are too large for me and too difficult to understand.

That said, I will examine Bank of America (NYSE: BAC) and specifically their “A” warrants, which trade as BAC-WTA.

BAC has been a prominent entity among various value investors (i.e. I’ve read many recommendations to buy them) and year-to-date their stock has tanked about 25%. I do not know why other than there is a general concern about the large-scale US banking system and the stress that is going on in the financial system (i.e. China’s pending devaluation, macroeconomic games being played, and the impact of a negative rate environment to name a few).

The warrants have an interesting feature – while initially issued with an exercise price of $13.30/share, the exercise price gets adjusted downwards if BAC declares dividends in excess of a certain amount. You can read the details on BAC’s site here. The warrants expire January 16, 2019, or about 2.94 years from today. The current strike price is $13.106/share.

BAC shares closed at $12.95 last Friday, while their warrants closed at $3.75. There is a ton of liquidity on the warrants so there is no premium associated with liquidity concerns.

Without knowing anything about the company at all, we will ask ourselves: Would we rather want to buy the warrants or the common shares?

The calculations are much easier without having to factor in the 20 cents/share annual dividend of BAC, so I will leave the extra (required) analysis as an exercise for the reader. However, any dividends would still work mildly against the warrant holders despite the strike price revisions – the strike revision is not a 1:1 relationship and the warrant holders do not get the benefit of receiving any cash on hand between today and expiry.

If you buy a notional $100 of common shares or warrants, the results after 2.94 years given certain price changes in the common shares is as follows:

BAC Common vs. Warrants Decision

A quick and dirty results table, not including the impact of dividends, of a notional $100 investment in BAC Common or BAC A Warrants at the end of February 6, 2016.
ChangeCommonCommon ResultOptionsOption ResultDiff
-50%$6.48$50.00$-$-$(50.00)
-45%$7.12$55.00$-$-$(55.00)
-40%$7.77$60.00$-$-$(60.00)
-35%$8.42$65.00$-$-$(65.00)
-30%$9.07$70.00$-$-$(70.00)
-25%$9.71$75.00$-$-$(75.00)
-20%$10.36$80.00$-$-$(80.00)
-15%$11.01$85.00$-$-$(85.00)
-10%$11.66$90.00$-$-$(90.00)
-5%$12.30$95.00$-$-$(95.00)
0%$12.95$100.00$-$-$(100.00)
5%$13.60$105.00$0.49$13.08$(91.92)
10%$14.25$110.00$1.14$30.35$(79.65)
15%$14.89$115.00$1.79$47.61$(67.39)
20%$15.54$120.00$2.43$64.88$(55.12)
25%$16.19$125.00$3.08$82.15$(42.85)
30%$16.84$130.00$3.73$99.41$(30.59)
35%$17.48$135.00$4.38$116.68$(18.32)
40%$18.13$140.00$5.02$133.95$(6.05)
45%$18.78$145.00$5.67$151.21$6.21
50%$19.43$150.00$6.32$168.48$18.48

Basic options 101 states that if BAC does not rise above the strike price, your warrants would expire worthless. However, we are concerned about the “break-even” point of calculation. Most amateur option traders fail to take into consideration the impact of an equivalent investment in common shares. If they were quickly asked what the break-even point of a call option trading at $1 with a strike price of $10 is, they will quickly say the common shares would have to be at $11, but in actuality the answer would be something higher than that because you could have invested in the common and received a higher gain.

So in BAC’s case, you can see that the indifference point is between 40 to 45% on the table. I will save the calculation and state it is 42.5%.

42.5% over 2.94 years implies a CAGR of 12.8% for break-even. This is a reasonably high hurdle for any stock.

What do we measure 12.8% against?

Analyst consensus is earnings of $1.69/share and contrasted to the $12.95/share price, this is a ratio of 13.1%. Return on equity is reported as 6.36%, but even if you take out some assumed junk on their book and normalize their equity to market capitalization, you still have a ratio of 10.8% there.

The quick conclusion is that I’d purchase the common shares rather than the warrants – the risk/reward on the common seems to be much better. If you’re interested in leverage, just buy the shares on margin.

Genworth MI – 4th quarter 2015 report

Genworth MI (TSX: MIC) reported their 4th quarter and year-end earnings yesterday.

I have been covering Genworth MI since 2012. While I liquidated a significant portion of the company in 2014, as a result of the price depreciation exhibited over the past three months I have taken the liberty to once again make MIC the largest position in my portfolio (at prices from 22 to 25 a share) as I believe it is trading well below my estimate of their fair value. Companies trading at a discount of over 1/3rd of their tangible book value and at a P/E of 6 either are fraudulent (which is clearly not the case with Genworth MI) or have external sources of perceived stress causing such an intense discount.

Financial Statement Review

I will pick off some salient details of their report.

1. From year-to-year the balance sheet saw an increase of about CAD$450 million of real assets (cash, bonds, preferred shares, common stock) relative to the end of 2014. Roughly half of this was through an increase in deferred premiums (money collected for mortgage insurance that is held on the liability column of the balance sheet until it is recognized as actual revenue in accordance to a model for historical loss experience) and a good chunk through retained earnings.

2. Premiums written were up to $809 million for the year, compared to $640 million the year before (a 26% growth). You can thank the CMHC for this. Alberta went down from 26% in 2014 to 22% in 2015.

3. They continued to add to their preferred share portfolio; they sold their common shares and moved to preferred shares, which is still sitting on an unrealized loss position of $33 million on a $281 million cost base; this is better than Q3-2015 which was $42 million unrealized loss and $236 million, respectively. Given the existing valuation state of the Canadian preferred share market, shifting to preferred shares is a value-added decision especially when considering the positive tax consequences of inter-corporate dividend income for insurance companies. 92% of their portfolio is rated “P2” and the remainder is “P3”.

4. The company repurchased $50 million of shares and outstanding shares is down from 93.1 million at the end of 2014 to 91.8 million on December 2015.

5. The company’s debt maturing in 4.5 years has a yield to maturity of roughly 3.5% (traded at 109 cents on the dollar at year end). Their maturity at 8.25 years out was trading at a very slight premium and is YTM 4.2%. Back on November 6, the company was exploring a debenture offering. Their cost of raising debt capital seems to be relatively low, so it is curious why they never proceeded with it.

6. Delinquencies have not materially picked up in Q4-2015 (rate still is 0.1%).

7. Minimum capital test ratio goes from 227% to 233%. Management has pledged repeatedly that their target is “modestly above 220%” in terms of capital management. It is getting to the point where they will likely execute on another share buyback, and considering the huge discount to book value, they should consider a dutch auction at around CAD$25 to get those shares very cheaply off the books instead of dealing with a thin marketplace (recognizing that Genworth Financial owns 57% of the shares outstanding). As they have 13% in excess of 220%, this translates into about $203 million in excess capital.

If they managed to buy back 8 million shares for $200 million, they’d be able to increase book value by over a dollar a share! At existing valuations it would make complete sense for them to go private, but since Genworth Financial is facing huge financial challenges, they’re not the entity that is going to do it. This is a contributor to the depressed share price of Genworth MI (the market knows that Genworth Financial is facing pressure to sell the entire asset for a pittance).

8. The company expects lower amounts of mortgage originations in 2016. This will negatively impact premiums written in 2016. They did take 4% market share from CMHC in 2015, however, which may offset the decrease in originations.

9. Loss ratio is expected to be between 25-40%, which is more than the 20-30% guidance given for the 2015 year. Loss ratio guidance has always typically been conservative in nature. Considering the combined ratio for 2015 has been around 40%, an extra 10% on the loss side would put it at 50% and thus not anywhere close to endangering the profitability of the company.

Extra thoughts concerning valuation

Stated book value per diluted share is $36.82 – this is 35% less than the current market value of $23.91/share. If the company continues to book premiums written at $800 million in 2016 and maintain a combined ratio of 50% (30% loss, 20% expense), this would still be quite an undervalued entity.

I see two issues of market price stress:

1. The perception that the Canadian housing market will collapse and cause a huge wave of defaults which would bring mortgage insurers down like what happened in the USA in 2008;

2. Parent Genworth Financial’s issues spilling over onto Genworth MI – Genworth Financial needs money out of their subsidiaries and the trickle-down effect of dividends will not cut it for them. They can consider capital transactions (share buybacks) and keep their proportionate stake which enables them to bleed money out of the company at an accelerated pace, but this would still not be adequate for their situation. The market is likely taking the MIC subsidiary down in value on the implied assumption of a fire-sale of the 57% stake in the company. Of course, Genworth Financial would have to be completely desperate to do it at a 35% discount to book value (not to mention a P/E of 6), but the question here would be: Would they be willing to sell the whole thing at book?