Yellow Media

Yellow Media (TSX: YLO) is an interesting case on how to value a company in an industry clearly in collapse (in this case, collecting advertising dollars by selling paper bricks known as phone books). They are trying to desperately diversify into the 21st century, but just like how newspapers have felt it very difficult to doing so with the same financial models in place, Yellow Media is also in an equivalent state. Although the company currently is cash flow positive, it is diminishing – the exercise in valuation is the future assumption of how rapidly this is diminishing and also whether there will be any flattening of the decay.

That said, the top-line operating cash flow number for the first half of 2011 was $199.6M vs. $293.5M in 2010; still a healthy amount of cash coming into the coffers. Common and preferred share dividends (at the annualized rate as of this writing) is about $118M ($59M for the half-year period at the newly reduced dividend rate), so there is currently room to accumulate cash and reduce leverage.

The company is quite heavily leveraged. As of June 30, 2011, senior to everything are the Medium Term Notes (with a varying series of staggered maturities) – $1,644M; and a $636M credit facility. Junior to this are the convertible debentures (TSX: YLO.DB), a $200M issue. The annualized interest bite on these securities is about $129M a year.

There are also four publicly traded series of preferred shares outstanding. Series 1 and 2 (YLO.PR.A and YLO.PR.B) have approximately 16.9M shares outstanding; these are convertible into YLO common at various dates at $2/share (or 95% of market value if YLO equity ever goes above $2.11/share). The principal value of these shares is $422M. The other series of preferred shares are perpetual with only a call feature (YLO.PR.C and YLO.PR.D) – both of these series give out a dividend and there are 13.6M shares outstanding, face value of $339M.

Yellow also sold Trader Corporation for a net $708M, which closed after the June quarter-end. During the release of this quarter, the company announced it was slashing its dividend from $0.65/share to $0.15/share and also stopping its share buyback so it can concentrate on repurchasing debt and preferred shares. At the end of August they have repurchased approximately $238M in Medium Term Notes, and some preferred shares.

A brief look at the valuation of the various securities – currently, the common shares are trading at 68 cents (giving the company a market cap of $348M, 511M shares outstanding). One item that is clear is that the common dividend is likely to not be sustained at the existing level – the $77M in after-tax cash flow out the window is going to be required to assist in the de-leveraging effort. Once dilution of the convertible preferred shares are factored in, another 210M shares will be added to the share count.

The convertible preferred shares are trading primarily as a function of the common shares (due to the fact that the company will likely convert the preferred shares into common shares as early as possible, especially as they cut the common dividend). This will save the company about $19M/year in after-tax cash flow. The perpetual preferred shares are trading roughly at 28 cents on the dollar (about $7 per share) and this translates into yields of over 20% – the risk is that the company will suspend dividends once they suspend the common share dividends. The market is obviously predicting that this will happen. If they do, they will save $22.4M/year in after-tax cash flow.

The next item on the seniority chain are the convertible debentures, which are currently trading at 41 cents. These convertibles mature in October 2017 (6 years to maturity), and have a 6.5% coupon, giving the debt a 15.9% current yield. Yellow cannot defer the interest payments or it will face default, so it is likely as long as the company has cash flow they will be able to pay interest on the debt.

The question for an investor is whether the company will be able to shore up its cash flow situation, and if so, whether it will be able to sustain indefinitely payments on its preferred shares or debt.

Interactive Brokers increasing margin thresholds

Interactive Brokers is the best accessible brokerage with respect to margin. They are also exceedingly inexpensive (for Canadian currency, their rates are currently 2.5% between $0 and $100k, 2.0% for $100k-$1M, and 1.5% above that). I have not employed margin for quite some time, but others can borrow money at low rates. Considering the prevailing interest rates, others see it suitable to leverage by borrowing very cheap money and investing it into income-yielding securities, while skimming the few percentage points. That said, the securities that are now available to leverage from now has a market cap limitation of US$250M or above, as they announced today:

As a result of recent market volatility, please be advised that IB is increasing the margin rates on low capitalization stocks (currently defined as companies with less than $250 million in market capitalization). The margin increases will occur in three steps beginning on Wednesday, September 21, 2011 and ending on Friday, September 23, 2011. The margin rates will increase to 50%, 75% and 100% at the open of business on 9/21/2011, 9/22/2011 and 9/23/2011, respectively.

The current list of stocks which are subject to this margin increase is subject to change. The current list can be found on the following page:

http://ibkb.interactivebrokers.com/node/1788

Upon implementation, any of the incremental margin increases may result in a margin deficit in the account. A margin deficit implies that an account becomes subject to automated liquidation. Please carefully review the current positions within your account and adjust the portfolio accordingly.

I suspect the brokerage firm has done some risk analysis on customer profile accounts and has determined that the concentration within these low capitalization stocks has reached a point where they could not spontaneously liquidate the securities at an acceptable price in the event the stock market crashes. In such an event, the brokerage would be left to cover the remaining shortfall in the customer’s account (as presumably the customer will not be cutting a cheque back to cover such a deficit).

Interactive Brokers (Nasdaq: IBKR) is a very well-run operation and they probably did not make this decision lightly as it will be costing them some money.

Arctic Glacier freezing over

Arctic Glacier (TSX: AG.UN) is in default of its second-lien loans, which means its first line creditors will likely come knocking.

On August 2, 2011, the company invoked a conversion to equity clause upon the maturity of its convertible debentures. The company issued 311 million units in exchange for $90 million face value of convertible debt, leaving those debtholders with trust units at a rate of 29 cents a pop. Miraculously, the units managed to stay at the 20 cent range for a couple days before plummeting to the 10 cent level as investors dumped units.

The company’s financial troubles continue as they still have a significant debt load from other creditors. It appears quite imminent that the unitholders, having faced an approximate 90% dilution, will finally be wiped out at the end of this process. After subtracting the debentures that were converted, the company has about $190 million in debt and annual cash flows have declined significantly to the point where they can no longer afford this leverage.

Items to watch out for in the upcoming week

All eyes continue to remain on the macroeconomic situation in Europe.

There is also the the other continuing drama in the Middle East area, but it is always difficult to determine whether it is media sensationalism working its ugly head or whether there is something genuine brewing there.

I note with interest half-way through the market session that commodity stocks are getting hammered. In particular, I observe that most of the oil/gas majors (e.g. Suncor (TSX: SU), EnCana (TSX: ECA), Canadian Oil Sands (TSX: COS)) are trading down despite the underlying commodity (West Texas Intermediate) remaining seemingly range-bound around the $90 mark.

I also believe the market is seeking resolution to the Greek debt crisis (specifically the formal point in time where the EU gives up on them), but just like how the resolution of the US debt ceiling failed to provide relief for more than a trading day, I do not believe the resolution of the Greek crisis will resolve the EU situation – in particular the key countries are Italy (10-year yield chart) and Spain (10-year yield chart) – if their yields go higher then the crisis will morph into something much larger. Italy did, however, pass a measure which closes the theoretical gap in their own deficit. The usual European bank suspects (Societe Generale, Deutsche Bank, etc.) are all trading down around 5-10%, pricing in some future problems.

Also, for the first time since the 2008-2009 financial crisis, Goldman Sachs (NYSE: GS) briefly traded under $100. Their preferred shares (e.g. GS-PB, callable, perpetual with 6.2% coupon) are still trading at around 99 cents of par value, so that side of the market is not seeing much fair, just the equity. If you go to page 157 of their last quarterly SEC filing, they managed to vaccuum up money out of the market in 48 of 63 days – this is significantly worse than their previous track records. For example, in the previous quarter (page 139) they made money on 61 of 62 days in the market. Think of who you are competing with if you are involved in the short-term trading business – at least in a Las Vegas casino if you shop around correctly you will get about 99 cents of equity on one dollar bet in a hand of blackjack. Against Goldman Sachs Casino, you will be lucky to see 90.

Links and after-tax calculations

I will preface this post by thanking Mark Goodfield at the Blunt Bean Counter for mentioning this site. I am quite happy to link to high-quality writers of Canadian finance that use their real names, and Mark has been on my very small list of site authors on the right-hand side underneath the “Canadian Finance” header.

In particular, I found his off-topic post about golfing at Pebble Beach to be highly entertaining. Since I am one of the world’s worst golfers, I can only live through the experience through other people and I note in sympathy of him having to be stuck in a foursome with an incapable golfer at Spanish Bay.

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My topic on taxation deals with the statement of before-tax and after-tax amounts. Taxation must be factored into all financial calculations (despite how much we dislike paying them), but most people intuitively think in terms of before-tax rather than after-tax amounts.

Here is an example: If you were given a choice of having $100,000 cash in a non-registered account or $120,000 in an RRSP account, which would you take?

Most people would take the $120,000 RRSP account.

However, the answer is not so clear. For example, if you decided to take the RRSP account and pulled it all out in one year, assuming no other income and a BC residence in 2011, you would be left with $86,425 in after-tax money to deal with.

If you split your withdrawals into two $60,000 batches, assuming the 2011 rates apply for 2012, you would still be left with $96,366 after-tax. Structured over three years would leave you with $102,043.

That said, if your goal is to invest the capital and generate income over a long period of time, it is far superior to do it through an RRSP than a non-registered account, where in the latter your returns will be whittled away by having to pay the CRA each year. With the RRSP, you would have a larger capital base to deal with and also the advantage of tax deferral.

However, if your primary method is to increase your wealth through capital gains, there are multiple scenarios where doing it through a non-registered account is superior to an RRSP – especially if your holding periods on your assets are of very long duration. For example, if you chose well and invested in something that returned 10% a year for 20 years (note this is exceptionally difficult to do!), spontaneously liquidated at the end of 20 years, you would have $566,733 at the end of the day. In the RRSP account, after withdrawal, you would have $473,639 after-tax.

Also note that if the investment is determined to be grossly over-valued at a point in time, that the penalty of “spontaneous liquidation” in an RRSP is zero, while the tax liability in a non-registered account increases as the value of the investment increases – there is a significant penalty for realizing a capital gain and an investor has to factor this into their calculations (which I did on this post). I find it personally very frustrating to hold onto investments that have appreciated beyond what I consider to be its fair value, but “prevented” from doing so because of the capital gains taxes that would be incurred as a result.

Financial modelling of the RRSP vs. non-registered scenario as I outlined above is not a trivial issue to answer. The specific variables involved include (but certainly are not limited to):
a. When you need money out of your RRSP (a function of age and personal situation with respect to financial needs);
b. Your tax situation for the next X years (including how the government will change rates over that period of time, how much other income you will generate during that time);
c. Your method of investment (as it impacts how taxes are applied, expectations of future returns).

One other component of before-tax and after-tax calculations concerns the implied rent in a rent-vs-own scenario in a real estate purchase. For an individual, a rent payment comes from after-tax funds, which means that if your rent payment is $10,000/year, the before-tax income required to generate such a rent payment, using a 30% marginal rate, would be $14,286 before-tax.

Assuming a GIC returns 10%, one would intuitively think that they would be indifferent if they invested $100,000 in a residential property vs. the GIC (note this excludes all other costs, such as maintenance, insurance, property taxes, etc.) since the “return on investment” is $10,000/year. However, either the GIC rate must be translated into the 7% after-tax figure ($10,000*10%*(1-0.3)), or the after-tax rental amount must be translated into the $14,286 pre-tax figure ($10,000/(1-0.3)).

It is important when doing these financial calculations that all figures are translated into either before-tax or after-tax numbers, otherwise there will be significant errors in comparative calculations.