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.

What to do with profitable option positions

If you are in a fortunate situation where you bought out-of-the-money options and then the market moved favourably in your direction to the point where the value of the underlying is at your estimate of where it should be, what do you do with your existing option position? You would have made a small fortune and there are a few options:

1. Sell the option – you will probably pay a higher spread since it is in-the-money and will be receiving less time value;
2. Sell the common, and wait for the exercise – doing this will expose you to the downside below the strike price and also give up the time value of the option;
3. Sell the common, and exercise – doing this will give up the time value.

In most cases, the best option is #4: Sell an at-the-money option.

This maximizes the time value remaining in the option. There is still downside risk, but your in-the-money option’s time value will increase at it approaches the strike price, which acts as a weak hedge.

I generally do not play with options because they are incredibly inexpensive instruments to play with (mainly spreads, but they are also commission-heavy). The few times it makes sense is always when you are receiving good value for money – in the most recent case it was something trading at a far lower volatility than it should have combined with an obviously retail order on the ask that I just had to hit. The other instance was selling high-volatility puts in instances where things couldn’t get any lower. Sometimes those automated models do offer some free money when they do so without regard of the fundamentals of the underlying stock.

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.

Financial crisis #2

The perverted effects of having a negative yield curve is finally hitting the financial markets. In particular, this is hitting the banking sector in Europe, but there is also spill-over effect in the USA as well – I had previously written about Bank of America, but this is also affecting other financial institutions.

However, I do have a general rule and that is whenever it hits the headlines of mainstream publications, it is likely closer to the 9th inning of the ballgame rather than the beginning.

I observe on the Drudge Report, which is usually ahead on things:

drudge

Once news like this starts getting on the covers of the various US magazines and such, then it is likely over.

Canadian publications are also picking up on the fact that the government bond yield curve is flat-to-inverting:

Target overnight rate: 0.5%
1 month: 0.43%
1 year: 0.42%
2 years: 0.35%
3 years: 0.35%
5 years: 0.48%
7 years: 0.79%
10 years: 1.01%

The half-point spread is a very pessimistic for the Canadian economy – people are willing to pay dearly for safety at the moment.

With government bond yields so low, investors must look elsewhere to obtain yield. This leads institutions into the wonderful world of corporate debt, and you can ask how the big 5 Canadian Banks (Royal, Scotia, CIBC, TD and BMO) are doing with all of their secured credit lines they’ve given to a lot of the oil and gas industry, in addition to their mortgage portfolios.

The Bank of Canada must be watching the sector like a hawk right now because if there is a cascade of confidence loss, things will get very ugly and very quickly. Conversely if this crisis starts to fade away, investors will be handsomely rewarded for taking the risk right now.

In the meantime, enjoy the volatility. The environment right now is once again reminding me of something like mid-2008 when everything is all panicky. Bargains that have good potential for double-digit appreciation are hitting the radar in huge frequency.

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.