Equity – Page 74

Dundee Corporation – DC.PR.C – Series 4 Preferred Shares – Amended Exchange Offer

You can read my previous analysis piece on the original exchange offer here.

Dundee Corporation has announced a revision to the exchange offer. This offer would have never been made if there were sufficient votes to accept the original exchange offer (2/3rds of votes required).

The management information circular has not been posted yet, but James Hymas beat me to the punch to providing some of his always excellent analysis on anything relating to preferred shares.

My own quick summary is: the deal stinks less compared to the original offer, but it still stinks.

The revised terms of the amended offer compared to the original exchange offer include:

– The removal of the $0.223/share consent payment for shareholders voting yes to the proposal before a specified date.
– The ability to redeem 15% of the issue on June 30, 2016 and a further 17% of the then-issue (i.e. another 14.45% of original issue size) on ~~June 30, 2018~~January 31, 2018;
– An increase of the dividend rate from 6% to 7.5%;
– Granting of 0.25 warrants to buy DC.A stock with a strike price of CAD$6.00 with an exercise price of June 30, 2019 (which will be listed on the TSX).

Closing Market Prices for Reference

DC.A: $5.95/share (no dividend)
DC.PR.B: $12.00/share (11.9% yield)
DC.PR.C: $14.43/share (6.2% yield)
DC.PR.D: $9.50/share (11.8% yield)

Analysis

The meeting date has been postponed to January 28, 2016, but shareholders of record on December 3, 2015 (per the original exchange offer) will have a vote on the matter. They chose to keep the original record date – a revised record date would include shareholders that were more willing to buy into the terms of a sweetened exchange offer.

By far and away the most important provision is the removal of the $0.223/share consent payment. This consent payment introduced the concept of a prisoner’s dilemma where if you believe the deal was going to pass, you would be incentivized to vote in favour of the deal despite how bad it was.

Without a prisoner’s dilemma, there is no incentive to voting yes for a marginal or mildly adverse offering (which was the only way the previous offering had any chance of passing).

This deal still stinks, but the removal of the $0.223/share carrot will remove votes in favour because (and this is my personal speculation) most of the shareholders are angling for the June 30, 2016 redemption.

So now, shareholders can vote against the proposal and face no “punishment” of having missed out on a consent payment.

Notably the consent payment for the intermediaries is still in effect – brokers will receive $0.1784/share for each vote in favour received by January 21, 2016 and $0.0892 by January 26; so if you are indeed in favour of this bad deal, it would be in your best interest to vote your shares at the actual meeting so the company doesn’t have to pay out consent payments to third parties!

The ability to redeem 15% of the shares on the original June 30, 2016 redemption date is “nice”, but not of material economic consequence. The subsequent tranche (14.45% of the original offering size) on ~~June 30, 2018~~January 31, 2018 is long-dated enough that credit risk considerations come into play (for instance, the company’s credit facility would have to be renegotiated at this point and you would expect their subsidiaries would actually start making money at this point).

The increase of the dividend rate to 7.5% reflects the very weak trading performances of the other two preferred share issues (yielding nearly 12% at current prices). James Hymas has done a much better job than I could explaining the quantitative details of this component. Credit risk, especially by redemption time, becomes a huge factor in properly determining the course of action for this exchange offer. Dundee is good for a June 30, 2016 redemption through the unused portion of their credit facility. After this, who knows?

I will attempt to ballpark a valuation of the warrants. The company stated the warrants would be listed on the TSX if the exchange offer is accepted and this would give preferred shareholders a venue to liquidate for immediate cash proceeds. While the historical volatility of Dundee common shares as of the past 30 days has been around 80%, their at-the-money options currently trade at an implied volatility of 42%. Using Black-Scholes valuation (which is not the best way to value long-dated options, but is good enough for paper napkin purposes such as this post) we get an option value of $1.84/share, or about 46 cents per preferred share (as each share would receive a quarter warrant).

Using some more formal methods involves different results – if you are that bullish on Dundee’s common stock, why bother playing around with the preferred shares when you can simply buy the common shares or even the other preferred shares?

Doing some simple sensitivity analysis, if Dundee traded to $8 (25% higher) between now and the January 28, 2016 special meeting, the implied value of the warrants per preferred share would be approximately 83 cents (50 cents intrinsic value and 33 cents time value), assuming implied volatility doesn’t drop (in reality – it would slightly). 83 cents does not come close to mitigating the capital losses that have occurred between the initial offering (when shares were trading at CAD$17) and when the exchange offer was proposed. Right now preferred shareholders are sitting on a $2.60 drop in market value and this exchange offer will come nowhere close to compensating them even with the increased coupon and partial early redemption rights.

I also find this statement to be amusing:

The determination of the Board of Directors is based on various factors, including a fairness opinion prepared by GMP.

Apparently the original exchange offer was fair, but the amended one is as well! Is there any offer that wouldn’t be considered fair by GMP?

Conclusion

Preferred shareholders have an even easier decision this time around – vote against the offer. It is still terrible compared to the existing Series 4 preferred shares.

As I have disclosed in my prior post, I sold out my DC.PR.C position between $17.20-$17.44/share in late November/early December. I’m a spectator at this point.

Update January 9, 2016: The initial part of this post had the second redemption date as June 30, 2018 when it should be January 31, 2018. The above has been corrected and the 5 month difference does not materially change the above analysis.

Dream Unlimited Preferred Shares

With the calamity hitting the preferred shareholders of Dundee Corp (of which I narrowly escaped), I have long noticed that their spinoff corporation, DREAM Unlimited (TSX: DRM) has a similar situation going on with their own preferred shares.

You will have to dig through SEDAR and look for a May 31, 2013 document that is 8783kb in size and go to page 60 of 141 in the PDF document for a legal definition of what these preferred shares are. They made it so convenient as the documents are not even made searchable with the usual control-F function on Adobe Acrobat.

They trade as DRM.PR.A and they are retractable by the corporation at $7.16/share, and redeemable by the shareholder at $7.16/share, in both cases with accrued dividends (7% coupon on a $7.16 par value). Redemption and retraction are given with at least 30 calendar days of notice.

Unlike Dundee Corp, there is no ability for DREAM Unlimited to sneak a shareholder-hostile proposal to scrap the redemption feature without a significant sweetener – if they did so, you can “vote” by exercising your redemption rights and get your money 30 days later instead of voting your shares against such a hypothetical proposal.

The only risk is the underlying corporation, DREAM Unlimited, elects to pay the redemption with common shares. The provision is 95% of the typical 20 day volume weighted average price scheme that is common to a lot of other offerings out there, or $2/share if this is the higher price. DREAM Unlimited common shares are trading at $7/share and with a market capitalization of $526 million, so a dilution of $36.7 million is not going to hammer the common shares below $2 if they tried an equity redemption – you’d likely be able to get out above par value in such an instance. The underlying business is not prone to “gap risk” (i.e. this isn’t some biotechnology company that will drop 70% one day due to a failed clinical trial), but it is in real estate development – this means that any of their properties that are not in Alberta or Saskatchewan, should be relatively stable (at least until you can get your redemption money in 30 days time).

In typical Dundee fashion, however, while the corporation is reporting considerable GAAP profits, their cash flow statements leave much to be desired. They do have ample liquidity in the meantime, having negotiated a $175 million million first-line facility with the banks expiring June 2018 and also $200 million of spare capacity on their operating line of credit which expires on June 2017. There is easily enough room to pay for a redemption of preferred shares – indeed, the fact that the preferred shares occupy a $36.7 million hole on their balance sheet probably forces them to be more conscious about this liability. I wonder why they haven’t even just bitten the bullet and redeemed this expensive capital.

In other words, the market value of this preferred share issue is going to be anchored around the $7.16/share mark as investors are able to skim off a 7% eligible dividend until such time the corporation bites the bullet and finally redeems the shares. If it goes too below $7.16, it is an easy arbitrage to buy below $7.16 and instantly redeem if you believe there is any sense of credit risk. It is as close to a risk-free 7% as it gets.

I note that the preferred shares were trading as low as $7.00 today and this was likely fueled by some investor out there getting his RBC Margin account spontaneously liquidated – it wasn’t a trivial amount either, around 40k shares worth. About 30,000 of them traded at $7.00 and somebody redeeming them back to the corporation at $7.16 made the easiest CAD$5000 on the planet. Ordinarily DRM.PR.A is not an actively traded stock and with all of the stress occurring in the marketplace, what may be “risk-free” isn’t as liquid as cold hard cash!

Anyway, I bought some shares at $7.00 today.

Revisit of Bombardier

There was an article on the Globe and Mail regarding my declaration that I had invested in Bombardier preferred shares (TSX: BBD.PR.B / BBD.PR.C).

I’m going to look very smart or very stupid at the end of this ordeal.

I will emphasize this is a high risk, very high reward-type opportunity. With high risk goes the chance for permanent capital loss, so the position size is appropriately small.

At current market prices, BBD.PR.B trades at a 12.6% yield, while BBD.PR.C trades at a 16.5% yield.

Other than the obvious business execution risk entailed within their aircraft division (specifically the execution of the C-Series project), there is another huge risk for investors: they will suspend preferred share dividends.

If this happens, BBD.PR.C will trade significantly lower (percentage-wise) than BBD.PR.B. The conversion risk is another component of the yield differential.

The comment about bond yields was accurate as of the middle of November, where after the government equity injections the short-term maturity bonds traded at reasonable yields. Today, however, yields have significantly widened, which also accounts for why the preferred shares are trading at such blowout yields.

Below is a graph of various yield to maturity curves of Bombardier debt (note these are NOT “yield to maturity” curves, I use a current yield + capital gain calculation which is non-standard but a more intuitive measurement for high yield debt I prefer using):

The near-term maturities have risen to the 10% yield levels, which puts the corporate entity in the refinancing danger zone.

Considering how much equity was injected into the company (US$2.5 billion) over the past few months, this is not exactly an enthusiastic market for debt, especially their March 2018 issue which matures in just 2.25 short years from now (albeit this specific issue’s last trade was 98 cents on the dollar – but go back another 6 months and that one traded at 90 cents!).

Part of this is likely because of year-end dumping for tax reasons, and the embarrassment factor of any fund managers that are holding onto this – they don’t want those shares to appear on their year-end financial statements to clients!

However, there is also a very deeply political component to my investment thesis. The Quebec investments are part 1 of the story. I’m waiting for part 2 to resolve itself (and this does not involve a federal government investment – if it happens, it will be icing on the cake).

Dundee Corporation – DC.PR.C – Series 4 Preferred Shares – Exchange Proposal – Analysis

Dundee Corporation (TSX: DC.A) has a preferred share series, Series 4, which trades as TSX: DC.PR.C. The salient features of the preferred share is a par value of $17.84, a 5% coupon, and a shareholder retraction feature which enables the shareholder to put the shares back to the company at par on or after June 30, 2016. The company has the right to redeem the preferred shares at $17.84 in cash or 95% of the market value of DC.A stock, or $2/share, whichever is higher.

I was going to wait for the management information circular to be released before definitively writing about this proposal, but my impatience got the better of me (in addition to me no longer being a preferred shareholder, which tells you what I think of the arrangement). James Hymas has written twice about this one (Link 1, Link 2) and his conclusion the was the same as mine when I read the arrangement: we both don’t like it.

Dundee announced they wish to change the terms of the preferred shares per the attached proposal as they do not wish to allocate what would functionally be a CAD$107.4 million cash outlay, puttable at any time by the preferred shareholders. The special meeting will be held on January 7, 2016 with the record date at December 3, 2015 (so shares purchased until November 30, 2015 are able to conduct business at the meeting with the typical 3 day settlement period).

Details of proposal

(ranked in my order from most important to least important)

1. Shareholder “put option” can only be exercised on June 30, 2019 (from the present date of June 30, 2016);
2. A consent payment for an early “yes” vote of $0.223 (one quarterly dividend coupon payment) and $0.1784 for the broker holding the shares!
3. Coupon goes from 5% to 6%;
4. Company will have redemption features above par (and at par at June 30, 2019) that realistically will not be triggered;
5. A “reverse split” at a ratio of 17.84/25 to adjust the par value of the preferred shares to $25/share making the math a little simpler;

The required vote is 2/3rds of the voting shareholders.

Analysis

Dundee Corporation is controlled by the Goodman family in a typical dual-class share structure. The corporation is a quasi-holding structure, with entities that are consolidated on the financial statements and some that are accounted for with the equity method. Thus, reading the income statement of the consolidated entity is not a terribly fruitful activity until one looks at the components. Most of the significant components are losing money. Considering that there are some heavy investments in oil and gas, and mining, this is to be expected. The best income-producing asset is the spun-off Dream Unlimited (TSX: DRM) which is a real estate development company. The take-home message is that the corporation as a whole is bleeding cash – about $25 million a quarter in 2015 to date.

Their balance sheet is not in terrible condition, but it is deteriorating – At Q3-2015 they reported $274 million in consolidated cash in addition to having a $250 million credit facility (with $93 million drawn) that expires in November 2016. However, most of the other assets are related to their heavy investments in the resource industry, which already received an impairment charge in Q3-2015, and likely to be impaired further.

So while it is very evident that Dundee will be able to pay their CAD$107 million preferred share liability when it is available to be redeemed on June 30, 2016 and beyond, the clause to extend the redemption date from June 30, 2016 to June 30, 2019 involves a pricing of significant credit risk over the incremental three year period, hence this deal being very unattractive for preferred shareholders – it is not entirely clear that the company will have any cash left to redeem the shares! The company does have the option to redeem the preferred shares in common shares of Dundee, but at this point the common shares might be worth under the CAD$2 threshold which is the minimum conversion rate.

Finally, the market does have valuation information on the other preferred share series trading – DC.PR.B and DC.PR.D – currently giving a 9% yield with no redemption possibilities – and this would suggest that the proposal of DC.PR.C, assuming a moderate “redemption” premium (i.e. with the shareholders receiving their money back in 3.6 years), would result in such shares trading at a minimum of 92 cents on the dollar, or roughly CAD$16.41 equivalent on today’s preferred share price (roughly a 4% price reduction on today’s CAD$17.00 trading price!). This assumes that there is equal “credit risk” with non-payment of dividends between now and the redemption date and no risk of receiving a lessened payment in 3.6 years – hence, 92 cents on the dollar would be a maximum valuation at present given market conditions.

Thus, the consent payment would need to be significantly higher than $0.223/share for preferred shareholders to be compensated for the extra three years of “holding risk” they are taking – my minimum estimate would be about $1.43/share for this to even be considered on par value, or $0.60/share when considering the existing market price of CAD$17. Taking the mid-point of this would be a $1/share consent payment. I would suggest that $0.60/share cash plus another $0.40/share in common stock be given for such a deal to be accepted. I’d love to see how the “fairness opinion” rationalizes this original deal being fair for shareholders – maybe fair for the company paying for the report!

Ethics

What is unusual about this proposal is that the intermediary (i.e. in most people’s cases, the broker that holds the shares) receives $0.1784/share that is tendered in favour of the deal. This clearly will create a conflict of interest between brokers and their clients. Ironically if that extra $0.1784 were applied to the beneficial shareholder, the proposal might have stood a higher chance of passing.

These tactics are clearly anti-shareholder and a huge red flag against management that would propose such a scheme.

Conclusion

My recommendation is that DC.PR.C preferred shareholders reject the proposal. It needs to be sweetened further.

I did sell all my shares between CAD$17.20 to CAD$17.44 on the open market last week and am happy to be rid of this headache.

For knife catchers only – Kinder Morgan

Kinder Morgan (NYSE: KMI) is in a chicken-and-egg situation. It needs financing to implement capital projects, but the cost of its financing has been steadily increasing due to its financing requirements.

Energy pipeline equities are a staple income producer for a lot of funds out there, but if they have their dividends threatened, the supply dump is going to be gigantic.

I sense this is a falling knife situation where it will be very difficult to predict the bottom. You can make an excuse for US$16.84/share being the bottom, or you can also make an excuse for US$9/share. It just depends on how many funds are hitting that sell button, irrespective of price.

Cash-wise, it is very evident they will have to cut their huge dividend. They are giving out US$4.5 billion a year and it is completely obvious they cannot sustain it given their capital spending profile (offset with their not inconsiderable positive operating cash flows). Refinancing their debt ($3 billion of it current as of September 30, 2015) is going to be progressively expensive as bond yields rise and their equity price drops. They do have a credit facility with $3.4 billion availability, but their buffer is thin!

I am sure Kinder Morgan will recover this financial earthquake, but how low will their common stock go before they recover?

Finally, let this be a lesson those that invest in highly leveraged industries (e.g. power generation, pipelines, etc.) – you never know when the market will arbitrarily pull the rug on your refinancing program.