Canadian Finance and Economics
Very interesting things happens to markets at bottoms and tops – there are typically panic spikes down and up.
My market instincts suggest that we’re approaching some sort of local maximum for fear in terms of the energy markets. All doom and gloom, and usually you hear about the opposite arguments (demand is rising, geopolitical risk, etc, etc.) but none of this is present.
Probably a reasonable time to shop for assets in entities that will be able to survive the trough.
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.
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.
Every year at around this time I scour the list of year-to-date losers because they are more prone to being jettisoned for two reasons:
1. They can crystallize a loss for income tax purposes; and
2. A fund manager does not have to be embarrassed by the presence of that security in their portfolio.
One can debate whether reason #1 or #2 is more powerful.
When looking at a very simple screen of Canadian stocks, it is evidently clear that anything energy and resource related has been disproportionately hammered. There are obvious reasons why this is the case – commodity prices – so these companies don’t require much further research. There are likely a couple golden needles to be picked out of the haystack. Those that can pick them out will be handsomely rewarded with a disproportionate out-performance whenever the underlying commodity recovers. Finding these golden needles will never be an easy process – if it was, other investors would likely be able to identify the opportunity which will impact your returns.
However, when scouring the list of non-energy and non-resource stocks, I get the following, in rank order of greatest loss year-to-date to least, with some very superficial remarks:
1. BBD.B – Bombardier – I’ve written about them in the past on this site. Their common shares are down 70% year to date! Preferred shares seem to be the sweet spot of risk/reward.
2. TTH – Transition Therapeutics – One look at their yearly stock chart can tell you when their clinical trial of their lead development candidate failed.
3. CPH – Cipher Pharmaceuticals – Will need to do some research.
4. SW – Sierra Wireless – January 1, 2015 seemed to be a peak in their stock price which is why they made this list. Perils of technology investing.
5. WIN – Wi-Lan – Patent company that is seeing the business model not be as promising as originally hoped. Not interested.
6. CJR.B – Corus Entertainment Group – Media company with various television and radio interests, facing too much internet competition.
7. TS.B – Torstar – Toronto Star. Print Media. Enough said.
8. AFN – Ag Growth International – An obscure but easy-to-analyze company selling grain equipment to farms across the world. 2015 was a fairly poor year for sales compared to 2014 and they’re going through a management transition, also distributing more cash than they are generating. They might have taken a little too much debt.
9. GVC – Glacier Media – Print Media. Enough said.
10. RET.A – Reitmans – Women’s fashion retailer. Will they go back in style? Were they ever in style? Their balance sheet is in shockingly good position ($165 million cash/marketable securities minus debt or $2.58/share!), and if the company ever learns how to make money with its marketing, the stock has very good potential. They’re not bleeding a huge amount of cash at present. I’m not smart enough to figure out whether management will figure out a winning formula – if they do, it could easily double from present prices.
11. LIQ – Liquor Stores – Razor-thin margins, coupled with acquisition-related debt, leaves an entity that makes some money but is highly susceptible to regulatory actions of the entities it operates in, coupled with their ability to maintain credit (albeit their existing facility is dirt-cheap as it is secured by an inventory that will not depreciate and can easily be liquidated – liquor!). They are paying dividends well in excess of their capacity to generate cash, so be warned that the 12% stated yield is an illusion.
Westshore Terminals Investment Corporation (TSX: WTE) is a holding corporation that owns all the limited partnership units of Westshore Terminals LP. The LP is controlled through a partnership agreement by Westshore Terminals Ltd., and functionally speaking control is held by Westar Management Ltd (not to be confused with another company, Westar Energy, which is unrelated).
The whole reason for the verbose description is that although it may appear at first glance that shareholders of Westshore Terminals have control over its operations, in reality this is a situation where shareholders are in the minority and external actors control the firm. One must always be mindful of the motivations of the controlling entity and whether there is significant alignment with shareholders.
Skimming the documents, I am not entirely sure who controls Westar or the General Partner, Westshore Terminals Ltd., but would assume the present directors of Westshore Terminals Investment Corporation have a say in the parent controlling entities.
Jim Pattison (a very prominent BC businessman that usually keeps his ventures privately held) owns 18.6% of the company as of May 2015. Since then his entity (Great Pacific Capital Corp.) has acquired another 4.1% of the company, according to SEDI disclosures, roughly at an average of $25/share. An early warning report on October 30, 2015 confirmed 22.5% ownership.
The whole Canadian investment world can see this public investment and thus one has to ask what Pattison’s firm is thinking.
Westshore’s entire business is about exporting coal, primarily to Korea, Japan and China/Taiwan. The coal is majority sourced (58% in 2014) through mines owned by Teck (TSX: TCK.B).
Financially, the corporation has been very profitable over the past couple fiscal years – earning about $130 million in profit over 2013 and 2014, and $101 million for the first 9 months of 2015. As the corporation has 73.9 million shares outstanding and is trading at $17.50/share, some simple math will indicate that they are trading at a P/E below 10 according to their historical profitability.
The nature of their coal exports can be divided into the following categories:
And here is where we have the problem – steel commodity in China has cratered. There’s various types of indicies and types of steel that you can measure (rolled steel, rebar, etc.) but all indications show that demand is dropping:
Adding to the woes of the coal industry is the fact that there is a gigantic supply glut of thermal coal due to western nations suddenly deciding they wish to phase out coal power generation. Taking a look at charts of Peabody Energy (NYSE: PEA), and Arch Coal (NYSE: ACI) should pretty much tell this story. Take a snapshot of their charts before they go into Chapter 11! Or if you don’t wish to waste your money on their equity, Peabody’s senior unsecured debt is trading in the teens – a fairly good sign of imminent capital restructuring.
Teck’s stock has also gotten killed over the past 5 years – an investor’s shares has gone from about CAD$60/share to CAD$5/share today, plus Teck’s corporate debt has cratered – e.g. their senior debt maturing in January 2021 (4.5% coupon) has the following ugly chart:
Despite Teck being rated Ba1 (Moody’s) or BB+ (Fitch), their debt is clearly trading in the junk status and one has to start wondering about counterparty risk when your medium-term debt is trading at such high yields (and the nearest liquid issue, January 2017, is trading at a yield to maturity of about 10% presently).
Financially, it just doesn’t look good for coal producers (most of them are deeply encumbered by debt), but does these financial issues reflect the actual economics of Weststar Terminals’ industry which is the shipment of coal?
Weststar does not have any debt on its balance sheet – its primary liability is the $91 million unfunded portion of its pension plan at the end of September 2015. It is primarily functioning as a flow-through operation for its shareholders and to this effect, it has reduced dividends from 33 cents to 25 cents quarterly as it anticipates increasing capital expenses and also anticipating a decrease in coal shipped, according to an October 28, 2015 corporate update.
So we have a perfect storm brewing in the coal world – decreased demand for steel, decreased demand for power generation, and thus lower shipments and lower revenues, spread on a relatively large fixed cost base – suggesting decreased profitability in the future.
This also doesn’t factor in the increasing scrutiny of coal shipments in BC from a political perspective. While the existing provincial government is clearly supportive, there is election risk for the upcoming 2017 election in terms of economic impact.
Westshore does have several advantages that cannot be easily obtained with competition. There are three terminals in BC that are in the same business – Ridley is up north in Prince Rupert, but they are limited in capacity (although well strategically positioned to take coal from mines in the BC northern interior). In the greater Vancouver area, there is Neptune and Westshore – Westshore has a significantly larger capacity, but Neptune is still under its capacity. Neptune is 46% owned by Teck as well, which will put it in conflict with Westshore.
The market has clearly seen all of these negatives and has subsequently “adjusted” the equity value of WTE very dramatically – about 50% over the past 6 months. The question as an investor would be:
1. Financially, what would the “trough” look like for Westshore? Does the underlying entity still generate cash?
2a. Will coal recover from what are decidedly anti-coal government legislative regimes (USA EPA, Germany, Alberta, and now possibly Canada?)
2b. If so, what would the timing be where enough supply has been stripped from the system, and perhaps a recovery in demand?
3. Competitively speaking, how much shipping capacity will the other two terminals in BC represent?
The answer to 2b will presumably rely upon the economic fortunes of Korea, China and Japan, all of which have their own internal issues to deal.
I will leave this post now as an exercise for the reader. No positions as of this writing.