Finance – Page 6

Liquidity needed! Race for the exits!

The fear over financial institutions is ramping up quite rapidly with Credit Suisse (NYSE: CS) next on the media radar for insolvency.

Pretty much every sector of the financial market is having a huge amount of supply pressure added to it, with the exception of gold commodity and long duration AAA debt.

Commodities, specifically oil and gas, are getting absolutely slaughtered over the past week, presumptively due to a forecasting of demand going off a cliff with the rest of the world economy.

Cash is an essential element in the portfolio – it just sits there and is generally disrespected until moments like these where it provides a layer of comfort.

Some surprises in this is that the CAD/USD is not lower than I would have thought given what is happening to fossil fuel pricing and the increase in VIX.

When central banks raise interest rates like they have, it was bound to cause some sort of financial earthquakes, but predicting where they hit is usually done only with the benefit of retrospect. The first casualty is improperly leveraged financial institutions. The spillover effects of this remain to be seen. Cash, however, is a good short-term defense.

The financial earthquake – some thoughts

Few appreciate liquidity until you don’t have it, and then everybody wants to rush out the exits – this is when you get price crashes.

With major US regional banks trading down significantly (examples: FRC, WAL, ZION, PACW) and with SI, SIVB and SBNY going into FDIC receivership, there will be some other consequences. I’ll write a few of them here:

1. The Fed is offering a “treasuries for par for one year” program. So if you were stupid enough to buy long duration last year, you’ve got a one year term grace period to figure things out – although inevitably your shareholders will have to choke on the loss (unless if the Fed really bails out everybody by dropping interest rates!). This can only be described as a time-limited QE action! However…

2. The yield curve has gone bonkers, with longer-term yields trading significantly down and the Fed Funds rates basically indicating one more quarter-point rate hike and that’s it:

3. Bitcoin and Gold have simultaneously received a huge bid, with BTC up +$4,000 to US$24,000 and an ounce of gold up $50 to $1915. There is obviously a huge pressure in the market for safety at the moment.

What is the big picture here?

1. A bank’s traditional model of riding the yield curve does not work very well in an inverted yield curve environment. The yield curve has been inverted for many months, and customers with zero-interest deposits are not going to be a stable source of capital if you’re running a bank;

2. The question of inflation – the central banks have a mandate to stamp inflation. This is also a function of what the BoC referred to as entrenched expectations of inflation. Ultimately the labour input function of inflation will get stamped down if we start seeing mass unemployment claims come to the fore. I’m suspecting that my prognostications of this happening in January-February 2023 (which I made later in 2022) are simply delayed – I’m going to guess we will see more of it coming, especially in the second half of the year;

3. “This can’t happen in Canada!” – the Bank of Canada in 2008 took considerable measures to backstop the major Canadian schedule 1 banks. The USA has JP Morgan, Bank of America and Citigroup, while Canada has Royal Bank and Toronto-Dominion as key global banks. While the stability of the banking system will be defended at all costs by central banks, whether equity/debt holders or not will take a bath is another question.

Let’s review the business model of a bank. Inherently it is a very simple business. You take deposits from customers and (usually) pay them for the right to hold their money for a time. Say your rate of pay is 2%. Parallel to this, you also lend money out to credit-worthy customers at a higher rate of interest. Say that you lend money out at 5%. In this example, for every dollar your are able to recycle, you get a 3% interest spread. Then you have to subtract all sorts of expenses relating to hiring staff, maintaining IT infrastructure, leasing branches across the country, etc., and after paying taxes on the residual, your shareholders make a profit.

Making a 3% interest spread is not efficient. To increase this amount, you do the procedure twice over – take in one dollar of customer deposits at 2%, and loan out two dollars to customers at 5%. You can do this because you have a deal with the central bank that if you keep a certain amount on deposit, you have a license to create money and leverage it off your net equity figure. If you can pull the 1:2 deal as described on this paragraph, then your effective margin is 6% on a dollar of deposits due to the power of financial leverage.

The magnitude of money you can earn is even greater if you raise a hundred million dollars in equity financing and use that to lend a billion to customers, which is typical for most banks.

Where does this blow up?

One is what happened to SI/SIVB/SBNY – the bank took their liquid customer deposits and dumped them into long-dated government securities which could only be sold for less than what they paid for it, coupled with the depositors wanting their money back, now.

The second mode of failure is if the customers you’ve loaned money to don’t pay back their loans. We haven’t seen this to any material degree (yet). However, if we start seeing defaults on construction loans in Canada, this might become material.

The third mode of failure is more subtle – for a prolonged period of time, you can’t obtain deposits from customers at a cheaper rate of interest than you can loan the money out for. This could happen if would-be depositors start to demand higher rates of interest, coupled with your customer screening division not being able to find credit-worthy customers to lend money to.

4. Financial companies in themselves do not generate wealth in an economy (i.e. manufacturing, farming, natural resource extraction, Netflix, etc.) but they facilitate it. Inevitably if the business that financial companies are financing are unprofitable, financing companies cannot be profitable by definition (businesses won’t be able to pay back loans). Companies that produce economic value, as measured by profitability, will survive this mess, while those participants that are forced to rely on low-cost capital will wither.

5. Hold onto your wallets, this will get pretty wild. I was originally thinking “sell in May and go away”, but perhaps I was a couple months too late with this prognostication.

More later.

The Lehman Brothers moment

Silvergate (NYSE: SI) and Silicon Valley Bank (Nasdaq: SIVB) have both suffered immense market value losses this week.

In the case of SIVB, the story is fairly simple – they had a huge duration mismatch between their (asset) held-to-maturity portfolio and (liability) short-term deposits.

Held-to-maturity assets are held on the balance sheet at cost value, while fair (market) value is indicated.

SIVB had a differential of $15.2 billion between the stated book value and the fair market value of such securities, while the total equity of the firm was $16.3 billion.

Assuming they liquidated everything at once, the entity as a whole would be worthless.

One other problem they had was that their source of capital (zero-interest bearing deposits) was getting pulled out very rapidly and the only thing they could replace them with was high-interest deposits.

It eventually crashed this week – going from $275 per share to what will effectively be a zero. The unsecured debt is trading around 40 cents on the dollar, but it remains to be seen whether there will be any recovery there.

This was a classic bank run, coupled with financial mismanagement by the bank – when the asset duration and liability duration are mismatched, and when your depositors decide they want their money now, if you can’t raise the short-term funds to pay the depositors, you’re forced to sell those held-to-maturity securities and that is when your capital adequacy ratios goes into the toilet – and the FDIC steps in.

The media will make this out to be a crypto/digital-currency related issue, but that was only part of the story (how the bank got all of these short-term non-interest bearing deposits in the first place). The stronger part of the story is mismanagement of the duration risk.

There will be some collateral damage here, but unlike Lehman (which was a much larger entity) I suspect this will be somewhat more contained, although will cause volatility ripples in the next couple weeks in the financial sector as financial institutions shore up their solvency/liquidity books. It is a warning shot across the bow of every institution out there – liquidity is golden.

A few small observations

A mixed post.

Where I was mistaken

I made a claim earlier that I thought employment around January or February of this year would be shown to decline, presumably due to a slowdown in demand and companies cutting costs. Unless if you were one of the victims of a big tech company’s layoff, wow, was I ever wrong with this! Gross employment trends continue to exhibit strength, consistent with anecdotal reports of employers finding it difficult to source labour.

So where was I wrong here? Is there a demographic issue? Are companies out there finding additional vectors of demand to necessitate employment? Or am I just premature with my prognostication? I’m not sure.

There are some hints on the Fiscal Monitor – income tax collections and GST collections are up over comparative periods last year, and especially corporate income taxes. The government is likely to report an improved fiscal balance as well. This leads me to the second issue, which is…

The progression of QT

Members of Payments Canada (a.k.a. financial institutions parking reserves at the Bank of Canada and earning the short-term rate) continues to hover at the $190 billion level. The recent slab of government debt maturing off of the Bank of Canada’s balance sheet got directly subtracted from the Government of Canada’s bank account at the Bank of Canada, but the GoC is still sitting with $65 billion cash as of February 15, 2023.

What does this mean? The presumed pressure on liquidity is not happening – yet. Banks can still lend out capital, but you have to have an awfully good proposition since they’re not going to give it to you for cheap interest rates. Why should they lend it out to you at 6% when they can keep it perfectly safe at the Bank of Canada and skim their 4.5%?

While there’s liquidity, it’s definitely a lot more expensive. When you combine what I wrote about employment above, coupled with real estate finding its two legs again (helps that there is zero supply in the market), makes me think that the Bank of Canada was incredibly premature to call a pause on rates – March 8th they’ll be guaranteed to stand pat, but perhaps we might continue to see rate increases if CPI doesn’t drop quickly enough in the next couple months. Also, the US-Canada currency differential is also going to widen as the US Fed will be raising rates for longer.

A public market investor at this point is facing a crisis of sorts. Asset prices (unless if you owned garbage technology companies) haven’t deflated that much, so what is trading out there is really not the greatest competition for the risk-free rate. You have cash.to giving off a net 4.89%, and when you look at some average 20 P/E company, one has to ask yourself why you should be bothering to take the comparative risk. Just look at the debenture spreadsheet and the spreads over risk-free rates is minimal.

Commodities

In the middle of 2020, the trade was a no-brainer. Ever since then, it has become less and lesser so, to the point today where it is no longer about throwing capital into random companies and winning no matter what – discretion has been critical from about June of last year. The meltdown in the natural gas market is one example of where an investor could have turned into roadkill, especially with leverage. In general, you can lose less money by investing in low cost structure companies, ideally with as low debt as possible. The problem is if you have a whole bunch of industry participants in a good balance sheet situation – the race for the bottom becomes brutal since they can mostly survive low commodity price environments until some finally do get eliminated due to high cost structures and/or high debt service ratios.

Teck

They explicitly had to disclose they’re looking into strategic options for their met coal unit, which would be a cash machine of a spinoff if they went down that route. Seaborne met coal has rebounded as of late and it would be really interesting to see the price to cash flow ratio assigned to a pure met coal unit. A comparable would be Arch Resources, and they are trading at 4x 2023 earnings. Teck does have considerable competitive advantages, however – better access to the Pacific and a lower cost structure, in addition to being able to pump out more coal. Stripping out the coal business would leave the copper and zinc business in core Teck, and the residual copper business might get a 20x valuation (looking at Freeport McMoran as the comparable here). When you do the math on both sides of the business (especially as Teck’s QB2 project is ramping up this year and will produce gushing cash flows at US$4 copper), the combined entity would be worth well more than $30 billion today. So with a little bit of financial engineering, Teck can generate market value from nothing.

Let’s look at the first 9 months of the year (which is abnormally high for met coal, but just to play along).

I have (for met coal) their gross profit minus capital expenditures, minus taxes, at around $4.5 billion annualized. Give that a 4x multiple and you have $18 billion. On copper, with QB2 at full swing, it should be (very) roughly $1.5 billion total for their consolidated copper operations and at 20x you get $30 billion. Add that together and it’s well over the existing market cap.

What you also do to complete the financial wizardry is that you load the coal operation with debt, say around $10 billion. Give it to the parent company as a dividend, or perhaps give it to shareholders as a dividend in addition to the spun-off equity and the projected return on equity will skyrocket (until the met coal commodity price goes into the tank, just like what happened two seconds after Teck closed on the Fording Coal acquisition before the economic crisis).

Despite the above calculation, I’ve been taking a few chips off the table. My overall position has continued to be of increasing caution, one reason being that I don’t have a very firm footing on what is going on.

Toxic financings

When interest rates are no longer zero and there is actually an appreciably large cost of capital, corporations with negative cash flows and heavy debtloads are finding terms like these three examples.

First example

Goodfood (TSX: FOOD), a previous Covid-darling (to-your-door delivery would clearly replace regular grocery shopping when a trip to Superstore would kill you with viral pathogens!) has been losing money since day one, and now they have exhausted their cash balances to the following point where they have to issue this debt:

MONTREAL, Feb. 06, 2023 (GLOBE NEWSWIRE) — Goodfood Market Corp. (“Goodfood” or the “Company”) (TSX: FOOD) is pleased to announce that it has closed an offering (the “Offering”) of $12,675,000 aggregate principal amount of 12.5% convertible unsecured subordinated debentures of the Company (the “Debentures”) due February 6, 2028 …

The Debentures will be convertible at the holder’s option into Goodfood common shares (the “Common Shares”) at a conversion price of $0.75 per Common Share. The Debentures will bear interest at a rate of 12.5% per annum. The interest portion for the period commencing on the issuance date and ending in February 2025 will be capitalized semi-annually and convertible at a price equal to the volume weighted average trading price of the Common Shares on the TSX for the five (5) consecutive trading days ending on the date on which such interest portion becomes due, plus a premium of 50%. As of February 6 2025 and until the Maturity Date, the interest portion will be payable semi-annually in cash. As of February 6 2026, Goodfood may repurchase the non-converted portion of a Debenture at an amount of the principal and accrued interest plus an amount providing the holder with an internal rate of return (IRR) equal to 18% for the period during which such Debenture will have been outstanding. The holders may require a repurchase on the same terms upon a change of control of the Company.

This second paragraph is a terrible clause for common equity holders in that there will be a share issuance in February 2025 that will be quite expensive. In addition, the entire issue, if converted at 75 cents per share, would constitute about 18% of the shares outstanding, not counting any dilution before-hand with the interest capitalization.

While Goodfood has stemmed some of the cash bleed, it’s cash position on December 3, 2022 sits at $28.5 million and it has a $9.5 million credit facility due November 2023, ~~$47 million~~ $35 million in convertible debt (TSX: FOOD.DB, FOOD.DB.A) due 2025 and 2027, and now this debt above. There are also the customary IFRS 16 lease obligations. The cash burn got down to $6 million in the first fiscal quarter (3 months ended December 3, 2022).

I am always very wary when companies have to obtain debt financing at double-digit returns. In rare instances, when a company’s back is pressed against the wall, the equity will be trading like such utter trash that it is a reasonable risk-reward ratio better than a casino to take a small position, but such situations are extremely risky in nature. Usually for the company to bail themselves out of the situation, equity holders have to take some sort of bath (either through Chapter 11/CCAA or a highly dilutive transaction) which makes an investment in a more senior part of the capital structure more lucrative.

Second example

Greenbrook TMS (TSX: GTMS), a company that operates trans-cranial magnetic stimulation clinics across the USA, has a corporate strategy of “We will lose money on every acquisition, but we will make it up on volume”. Suffice to say, such strategies will require capital.

On July 14, 2022 they made an agreement with an asset manager for a US$75 million credit facility and the material term was:

The Credit Facility provides Greenbrook with a US$55 million term loan, which was funded on closing. In addition, the Credit Facility permits Greenbrook to incur up to an additional US$20 million in a single draw at any time on or prior to December 31, 2024 for purposes of funding future M&A activity. All amounts borrowed under the Credit Facility will bear interest at a rate equal to the three-month LIBOR rate plus 9.0%, subject to a minimum three-month LIBOR floor of 1.5%. The Credit Facility matures over 63 months and provides for four years of interest-only payments.

Three-month LIBOR plus 9% these days is around 13.8%.

On February 7, 2023 they announced:

The Company announces that it has entered into an amendment to its previously-announced credit facility with Madryn (the “Credit Facility”), whereby Madryn and its affiliated entities have extended an additional tranche of debt financing to the Company in an aggregate principal amount of US$2.0 million, which was fully-funded at closing (the “New Loan”). The terms and conditions of the New Loan are consistent with the terms and conditions of the Company’s existing aggregate US$55.0 million loan under the Credit Facility (the “Existing Loan”) in all material respects.

The New Loan also provides Madryn with the option to convert up to approximately US$182,000 of the outstanding principal amount of the New Loan into common shares of the Company at a conversion price per share equal to US$1.90 (the “Conversion Price”), subject to customary anti-dilution adjustments and approval of the Toronto Stock Exchange (“TSX”). This conversion feature corresponds to the conversion provisions for its Existing Loan, which provide Madryn with the option to convert the outstanding principal amount of the Existing Loan into common shares of the Company at the Conversion Price.

Sweet deal.

Third example

Bed Bath and Beyond (Nasdaq: BBBY) fights away Chapter 11 with a really toxic financing:

UNION, N.J. , Feb. 7, 2023 /PRNewswire/ — Bed Bath & Beyond Inc. (the “Company”) (Nasdaq: BBBY) today announced the pricing of an underwritten public offering (the “Offering”) of (i) shares of the Company’s Series A convertible preferred stock (the “Series A Convertible Preferred Stock”), (ii) warrants to purchase shares of Series A Convertible Preferred Stock and (iii) warrants to purchase the Company’s common stock. The Company expects to receive gross proceeds of approximately $225 million in the Offering together with an additional approximately $800 million of gross proceeds through the issuance of securities requiring the holder thereof to exercise warrants to purchase shares of Series A Preferred Stock in future installments assuming certain condition are met. The Company cannot give any assurances that it will receive all of the installment proceeds of the Offering.

At the initial closing, the Company will issue (i) 23,685 shares of Series A Convertible Preferred Stock, (ii) warrants to purchase 84,216 shares of Series A Convertible Preferred Stock and (iii) warrants to purchase 95,387,533 shares of the Company’s common stock.

While I haven’t read the terms and conditions of the S-3 filing that references the preferred securities and warrants as above (off the top of my head it is not clear what the strike price of both sets of warrants are), I can guarantee there’s huge dilution. What’s even more impressive is that the Reddit WallStreetBets and pretty much the whole financial universe is treating BBBY as the Gamestop of 2021:

This is simply insane trading. Multiple opportunities to make and lose money on a very liquid market (and option implied volatility is sky-high, especially on yesterday’s 100% spike up to ~$7/share). This casino-like trading is one reason why I think central banks are quite intent still to keep sucking liquidity out of the marketplace (QT), until this sort of thing ends.

Take-home message

Tightening financial conditions are triggering marginal companies (ones that have negative cash flows and debts) to engage in toxic financings. At what tier will the debt contagion persist? If you own shares in companies that are going to face financing crunches in the upcoming year or two, you may wish to brace yourself.