Holloway Lodging REIT – Default on radar screen

The last time I wrote about Holloway Lodging REIT (TSX: HLR.UN) was back in December when there was a corporate governance spat between a significant shareholder and management. That conflict resolved differently than what I had expected, with the significant shareholder being given a minority slate of trustees.

I have been continuing to dump my debentures in Holloway (the 2012 issue, TSX: HLR.DB.A) at around the 65 cent range and got rid of my last piece today at 62, leaving $1,000 in par value of debt just so I can see how this train wreck ends.

Holloway released their 2010 annual results yesterday, and reading it contains two not-so-subtle inclusions on their financial statements and management discussion that warrants further analysis:

The REIT is also subject to financial covenants on its mortgages and loans payable, which are measured on an annual basis and include customary terms and conditions for borrowings of this nature. These include the Debt Service ratio presented above. The REIT is in compliance with, or has obtained waivers for all of its financial covenants except one. One lender has not provided a waiver however, as a result of discussions with this lender, management believes the loans will not be called prior to maturity. The two mortgages with this lender, on hotels in Fort McMurray and Drayton Valley, are included in current liabilities and mature in October 2011 and January 2012.

Notably, the company has $153M of mortgages outstanding which are secured by the property and buildings within those mortgages. If the company does not abide by their debt covenants, in theory, the lender can call the debt unless if the company can cure the breach. If this occurs it would likely result in the company being pushed into creditor protection as their line of credit is not large enough to cover the difference.

The REIT has $25.4 million of mortgages maturing in 2011. The REIT expects to refinance its maturing mortgages at similar or better terms with existing or other lenders.

The REIT also has $20.2 million in convertible debentures that mature on August 1, 2011. The REIT has a signed term sheet to finance the repayment of the debentures. The Board and management continue to explore other alternatives to raise funds to repay the debenture holders which may include other debt financing, the sale of certain properties or some combination, thereof.

HLR has $45 million in debt in 2011 that they must be able to roll over in order to avoid creditor protection. The mortgage debt they should be able to renew at acceptable rates (they did so in 2010 for about 6.6% for a 5-year term). The August 1, 2011 debenture is an interesting issue ($20M) in that it is trading near par (TSX: HLR.DB, 93.5/97 bid/ask presently, albeit very illiquid) which suggests the company can refinance that, but the June 30, 2012 debenture (a $45M issue) is down to 62/63. This suggests the market is betting on the company being able to rollover the 2011 debt but not the 2012 debt. Both debentures are equal in seniority to each other.

It would be a logical and low-risk paired trade to short the 2011 debenture and long the 2012 debenture, but I could not short the 2011 debenture.

The business is not generating a sufficient amount of cash and this is in large part due to the interest bite that comes out of operating income. In 2010, the business pulled in about $19.3M in operating income, but the interest expense was $15.8M. This does not leave much room for other incidental expenses, such as general and administration, and future capital expenditures. Capital expenditures in 2010 I am presuming were of a maintenance-type nature, totaling $3.6 million.

There is nothing to suggest that they will be able to improve their revenue per room or capacity utilization rates over the next couple years.

There is probably residual value left in the operations, but I don’t want to be around to find out what low-ball offer management will be offering to the convertible debenture holders when maturity comes around. I’ve exited the 2012 debentures, short of $1k par value. My basis was about 44 cents on the dollar, so this is a nice gain for nearly 2 years of holding, but as I pointed out earlier, one of my largest mistakes during the 2008/2009 economic crisis was putting money in the debentures of this company compared to Innvest (TSX: INN.DB.B) at the same time period.

Questrade – Cash withdrawing is timely

Out of all the issues (1, 2) that Questrade has, cash management is not one of them. I have made several cash withdrawals through the course of late 2010 and 2011 as I have exited my debenture positions and they have been deposited via EFT to my bank account in a timely fashion.

I have been scouring the internet and have been reading nothing but trouble stories from people as they have done significant back-office migration since early February. It generally does not inspire confidence, which is why I entrust most of my idle cash balances to Ally (up to the CDIC limit!) and Interactive Brokers.

As long as you keep your transactions simple with Questrade, you should have no problem with them. If there is anything out of the ordinary or anything that could possibly warrant human interaction, then your mileage will vary – greatly.

Petrobakken – Value trap

(Update, June 23, 2011: Readers may be interested in further coverage of Petrobakken by clicking here.)

Petrobakken (TSX: PBN) has been on the top of my radar screens for oil and gas companies for quite some time. The reason is fairly simple – it appears to be a high-yielding security that has a large amount of reserves and land rights. During my extensive investigations of this company during the autumn of 2010 (when the common equity was at around $23/share) I rejected PBN as an investment candidate.

The past three years of trading have had investors seen their better days in earlier times:

The drop in late 2008/early 2009 can be attributed to the economic crisis and the decrease in oil prices, but the price drop lately can be solely attributed to financial management. In 2009 and 2010 the company engaged in a series of significant purchases with companies with large holdings in the Bakken oil fields (southeastern Saskatchewan). It also has significant holdings in the Cardium (roughly northwest of Calgary and south of Edmonton). These acquisitions were very costly and ended up hurting shareholders.

The company is paying off about $180M/year in dividends to its shareholders when it is spending far above its operational cash flow to drill for more wells in order to keep its production levels steady.

The large dividend yield probably serves as a psychological crutch for investors, in addition to providing its parent company, Petrobank (TSX: PBG), with a cash stream. Petrobank owns roughly 60% of Petrobakken. This appears to be a classic example of knowing the risks of investing in companies that are majority-held or controlled – a retail investor’s interest may not be in alignment with the parent company, and when this is the case, you may receive an adverse outcome.

The big operational issue in the Cardium and Bakken fields is that your production falls off steeply after the initial drilling (as opposed to your typical Steam-assisted gravity drainage project that a company like Cenovus does):

Although the capital expenditure can be justified, the economics are not as pleasant as what most people may anticipate by looking at the “trend” of oil production based on first year results. Most of the growth in revenues has to be looked at with the knowledge that the first year of wells will be extraordinarily high, while the second and subsequent years will have slower, but steadier production.

In 2010, PBN took in about $562M in operational cash flow, but they also spent $36M repurchasing their common shares (questionable given their balance sheet), $812M in capital expenditures, $483M in corporate acquisitions (mainly for land rights discussed previously). When you net everything together, the company had to borrow $750M in cheap financing (6-year notes, 3.125% coupon) and also maintain a line of credit with a bank ($825M outstanding of $1.2B available) in order to finance all of this spending and payouts.

Although the company is producing a lot of operational cash flow (in particular, they like quoting the statistic funds flow from operations, which was $3.51/share in 2010), in order to maintain this cash flow they need to continue spending significant sums of money on capital expenditures.

The valuation then becomes a matter of determining the decay rate of the various wells drilled on the Bakken/Cardium fields and the prevailing price of oil – and there are smarter people than myself that can model the decay rate better.

Most retail investors, however, would just look at the dividend yield at the current $19.60/share and say “Wow, look, 4.9%!” and buy in, not realizing that the company has probably hit the point where it can’t borrow money as cheaply as it has in the past. If you look at the GAAP net income, 26 cents per share does not look that impressive compared to the share price. One does have to model for a significant amount of depreciation (which is a non-cash expense that represents money already paid for drilling) in order to receive a more relevant free cash-flow figure.

This is not to say that Petrobakken is not a legitimate oil company – just that to my knowledge, its equity valuation does not represent an under-valuation at present, even factoring in the existing price of oil.

CN Rail or CP Rail – A look at the Railways

People trying to get on board the Warren Buffett bandwagon and are too cheap to purchase a Class A share of Berkshire Hathaway (currently $129,538/share) to participating in Burlington Northern are looking at other publicly traded rail options.

These include the following American names:
CSX (NYSE: CSX) – Eastern USA, competes with NSC
Kansas City Southern (NYSE: KSU) – Mid-Southern USA and both sides of Mexico
Norfolk Southern (NYSE: NSC) – Eastern USA, competes with CSX
Union Pacific (NYSE: UNP) – Primarily competes with Burlington Northern

In Canada, there are two majors:
CN Rail (TSX: CNR) – Very large network from Prince Rupert and Vancouver on the Pacific to the St. Lawrence River and Halifax to the Atlantic and New Orleans to the Gulf of Mexico.
CP Rail (TSX: CP) – From Vancouver to the St. Lawrence River.

The railways trade at roughly the same valuations – very roughly, around 16-20 times earnings, depending on the company. There are reasons for these earnings differentials, mainly balance sheet factors.

Comparing CNR and CP, CP rail appears to be a tad cheaper right now, but both are relatively expensive for what you are purchasing – a utility-type company that will continue to be very profitable in the future as energy prices increase. They will once again decrease in valuation when the physical amount of goods in the economy slows down, like things did in the second half of 2008.

Although both companies are well run and profitable, they are classic examples of such companies that you would not want to invest in unless if you wanted to invest a huge amount of money in them for the purposes of stability. Even then, one would think that waiting for the next recession would give you a better entry point.

Start of a correction or just a pause?

The uptrend in the market indexes over the past 7 months has been noted by many, but due to geopolitical instability and the rising price of crude, the uptrend has taken a break. I note before when this also happened:

I do not know whether this is the “top” or whether this is a head-fake on the way to an S&P 500 at 1400. Time will tell.

Although one day does not make for the market’s direction, crude equities fell significantly today. The long commodity trade is very crowded and whenever this condition occurs, the risk of being long becomes progressively higher – momentum can only take you so far. Prudent investors will take money off the table and be patient, and let the greedy ones get burnt.

I wish I had something more to write other than that I have been continuing to take money off the table, and also putting capital into one other obscure US-based equity position that is not listed on any index, and appears to be relatively under-valued at the moment.