The first few days of November

The big looming issue is the US Congressional Elections. Since the actions of the US government have a heavy influence in the marketplace (e.g. raising taxes), I will be taking a break and watching the show. Expect posting to be light for the next couple days.

Almost all the pundits are predicting the Democratic party will be losing control of the US House of Representatives, and possibly the Senate, but either way this will mean gridlock for the US government – something traditionally favourable to the market since it is difficult for a split government to implement rule changes that increase risk.

Potash Corporation takeover should be approved

The Canadian government has until November 3 to make a decision on whether they will allow the takeover of Potash Corporation (TSX: POT) to proceed.

I do not know what the decision will be politically – the only time that the Canadian government has exercised its right to refuse a foreign takeover of a Canadian company was in 2008 when Macdonald Deitweiller (TSX: MDA) was prevented from selling itself as Canada did not want its sole satellite manufacturer going into foreign hands.

As a matter of public policy the sale should proceed. First, the buying company is overpaying. Secondly, the media (and Saskatchewan government) is making it sound like that Potash Corp is the only potash producer in Canada – while they are large, it is not the only source of Potash production in the country.

If the Canadian government refuses this sale, you will likely see any built-in takeover premiums of large Canadian companies be reduced. This is also an increasing trend as of late – governments trying to protect their strategic interests in natural resources, including oil and gas, uranium, water, metals and other resources. One wouldn’t be shocked to see the ultimate resource – intelligent people – be a future (but hidden) consideration in the future.

Politically, however, the decision might be different.

Trading credit principal for quality – TFSA update

As readers here may remember, my TFSA investment (which I am trying to compound as quickly as possible) was in First Uranium debentures (TSX: FIU.DB), unsecured senior debt, coupon 4.25%, maturing June 2012.

This has been one of my lesser performing investments, due to a horrible entry point (the company announced some adverse news shortly after my investment), which I had an opportunity to see the writing on the wall and liquidate (which I could have received a very acceptable price), but unfortunately my worst decision in the year was to not.

Anyhow, my TFSA is currently sitting about $600 below the end of December 2009 mark (netting out the $5,000 deposit), which is not too good since my other (fixed income) investment candidates at the time would have resulted in an actual increase on investment, which is the whole point of the TFSA. If I was planning on losing money, I would have prefered to do it in the RRSP or in the non-registered account so I could deduct the loss. C’est la vie – that’s how things work sometimes. The question is now, how to get back on track?

The first thing to look at is whether the underlying securities are still worth keeping based on new information that has been received in the interim. First Uranium went through a recapitalization which saw common shareholders be diluted in the form of a convertible notes offering (senior, secured by all assets minus what Gold Wheaton is entitled to, maturing March 31, 2013, convertible at $1.30/share, 7% coupon, TSX:FIU.NT) and a 14 million share settlement to Gold Wheaton (TSX: GLW) since FIU did not finish constructing a mine module in time. The company itself remains active in the gold mining industry (despite the company’s name, Uranium is a small part of the business), having two mines operating – Mine Waste Solutions (which is operating well and is profitable) and Ezulwini (which has been a basket case operationally and has been losing money). After firing most of the board and management, it appears there are hints that the company is coming back to financial life again, especially with gold prices at the high prices they are at today.

The company’s financials, once they stop spending big cash on capital expenditures, should be cash generating and healthily profitable even if you believe they will moderately underperform the economic projections in the technical reports. So it becomes a matter of whether the market believes the management can deliver operationally, and whether the management is credible. Given the history of the company, they are not and the common stock and debentures trade as if this is the case.

Thus, this is a high risk, high reward scenario. I have only gone superficially into one of the risks in this post, but there are other risks that I have mentally dissected.

While I do not think this investment is a slam dunk, when you adjust it for risk/return, there is a compelling investment thesis on the debt of First Uranium, and possibly the equity, which appears to be somewhat undervalued. There is a huge amount of default risk for the equity holders, and some risk for the unsecured debenture holders, and limited risk for the secured note holders.

The TFSA transaction that I recently performed was to sell half the debentures ($12k face) at 70 cents on the dollar, and then use the proceeds to purchase $10k face of notes, which I subsequently purchased at 88.5 cents on the dollar.

Why would I trade lower priced unsecured notes, maturing earlier (and a better annual compounded yield at existing trading prices) for more expensive, secure notes with a later maturity and less yield? The quick answer is that I am trading yield for quality.

The longer answer is that I am reasonably confident that the secured note holders would be able to receive the full principal amount in a bankruptcy liquidation of First Uranium. There is $150M outstanding and the company is likely to fetch more than this from Mine Waste Solutions alone. The upside for the noteholders (beyond a payout at maturity) is the $1.30 strike price, 2.5 year call option embedded in the notes, which provides a mild amount of equity participation without actually having to own the equity. The equity is currently about 67% out of the money as of this writing.

If FIU does get its act together, it is likely that the equity will increase higher than 67%. However, the equity is far too risky in the TFSA – it is better suited to a non-registered account where you can at least book capital losses if it tanks.

Finally, there is the scenario of what happens to the unsecured debenture holders when their maturity hits (June 2012) – the company will either likely make an offer to extend the maturity or give the debenture holders a sweeter deal (higher coupon and lower conversion rate) while the company tries to make its mining operations profitable. I do not think the unsecured debenture holders will force the company into bankruptcy simply because of their rank – they have relatively less negotiating power.

I will emphasize that equity in First Uranium is a highly risky investment, and the debentures are a risky investment, but the notes appear to be less risky, and are priced to represent the lower risk.

The notes are also better positioned in the TFSA (since you will likely see your money back), while debentures are better positioned in the RRSP (income is tax-deferred, but you can still benefit if you have a loss of prinicpal), and equity is positioned in the non-registered account.

Oil company valuation – general note

Most oil producing companies also produce natural gas. Since natural gas is an input to gasoline production, typically companies internalize their natural gas production to their operations. However, many oil and gas companies produce excess natural gas and this contributes to their income.

Watch out for some earnings disappointments due to lower natural gas prices. Cenovus (TSX: CVE), for example, announced less than consensus earnings this morning due to natural gas pricing. Another company that is due to report that has significant natural gas production is Arc Energy Trust (TSX: AET.UN).

I am just a passive observer of these two companies, in addition to many others in the sector. There are nuggets of value here and there, but all of those are in the non-dividend bearing category. Companies like Cenovus (and its sister entity, Encana) are good stores of value in energy, but are unlikely to triple in valuation if energy commodities increase. They should almost be treated like annuities, assuming fossil fuels are not supplanted by something with superior energy density in the future (not in my lifetime).

The CN Rail Cash Machine

CN Rail reported their Q3-2010 result; it indicates they have recovered well from the economic crisis.

Although CN’s equity price is relatively high in terms of the cash they are able to deliver to shareholders (most notably they are spending about $300M/year above the rate they are amortizing), there are worse places to put “stable” cash – the equity trades more like a bond. This is another example of when people talk about “asset classes” that you cannot just put a blanket on “Canadian equity” and consider every share of every corporation to have the same risk/reward characteristic.

In terms of the actual numbers, the business was able to generate about $2.78 per share of free cash flow over the past 9 months. Annualized, this is about $3.71 in free cash, on top of a $67 equity price justifies the “relatively high” remark with respect to valuation.

Despite the high price (which is very near all-time highs), it is likely that CN’s total return over the next 10 years will outperform the equivalent Canadian 10-year bond, which yields 2.74%. The railways (CN and CP Rail) will likely be successful cash generating entities as long as Canada and the USA remain politically stable, and also are a benefactor of high energy prices – freight rail competes very well against trucking when it comes to goods movement.

Unlike most utilities, all railways have one very valuable piece of paper which is impossible to obtain – the right of way in major urban centres. If you were to give somebody $100 billion from scratch and got them to construct a railway, there is no way you could transform that capital into an income-bearing instrument that would yield better than the government bond. One of those reasons is property acquisition and track right of way – something Warren Buffet was thinking about when he bought out Burlington Northern. The only way you’d be able to get any sort of reasonable return is just to buy the railway outright, but even then the government could step in, citing “national interests”.