Mirion Warrants – Nuclear Insurance

I recently took a position on warrants that trade on Mirion Technologies (NYSE: MIR, warrants trading as MIR.WS). My average entry was under a dollar per warrant.

Nuclear Insurance

There are a small number of companies out there that specifically deal with the nuclear industry and even less that are pure plays. You can invest in generalized engineering companies like Fluor (NYSE: FLR) or GE (NYSE: GE), but they have a lot of non-nuclear operations which dilutes the sector interest to an insignificant level. You can also invest in power generation (e.g. Tokyo Electric, 9501.JP), but power itself is a commodity and you are investing in commodity-like characteristics. Likewise the same can be said for Uranium producers like Cameco (TSX: CCO). There are a handful of firms that can be considered pure plays.

One of the historical pure plays in this sector was a radiation detection company called Landauer (formerly NYSE: LDR), but in 2017 they were taken off the public market via acquisition by Fortive (NYSE: FTV), a very large diversified instrumentation company. Another one that I have written about in the past is BWX Technologies (NYSE: BWXT), which its primary moneymaker is producing nuclear reactors for US Navy vessels, but for various reasons I divested myself of this investment earlier this year.

Mirion is a pure play. It is an aggregation of various products relating to radiation biophysics, including medical imaging and also industrial imaging and the like as it relates to the radiological side of things.

I want to clarify the term nuclear insurance. It is specifically looking for a company that will rise in price dramatically whenever there are threats of nuclear catastrophes, likely due to geopolitical concerns or improper operations of nuclear reactors. To be clear, this is assuming that financial markets will still be functional after such an event – if this is of the scale where you have thousands of nukes thrown across the planet, there will be bigger problems to deal with!

The general theme of this trade is thinking of the biological analogy of what happened with Alpha Pro Tech (TSX: APT), a personal protective equipment manufacturer, during the onset of Covid-19:

This company rose by a factor of about 10x from early January to March 2020 when things got really hot and heavy. I would suspect in a nuclear scenario, Mirion would exhibit a similar price curve and hence the ‘insurance’ as probably every other component in the stock market would evaporate at about the same speed as something at ground zero.

Mirion, the company

This trade would be so much more attractive had the corporate entity had better characteristics, but sadly it does not.

Mirion can be described as a broken SPAC offering, going public in October of 2021. The predecessor name was “GS ACQUISITION HOLDINGS CORP II” and merged into what is Mirion today. It was the typical arrangement, going ‘public’ at $10/share with some warrants. Any investors in the SPAC post-closing (who are these people??) have lost money. As of April 2022, about 40% of the company economically is owned by Goldman Sachs entities. 20% are owned by two other hedge funds. The long-time founder and CEO owns about 2% of the stock. The Goldman entities are actively divesting stock – indeed, the principal officers have a listed occupation as “Goldman Sachs” which is amusing in itself. I’m sure the follow question gets asked at cocktail parties: “What do you do for work?” Answer: “Oh, I’m a Goldman Sachs”.

The corporation has a dual class structure, but the second class of stock does not convey any disproportionate privileges.

I’ve discussed above what the company actually does, and it is not a fly-by-night operation. They have about 2,600 employees, and 75 US patents (which you can search for and contain headlines that are in the relevant domain area).

The big problem is financial. The company has a balance sheet issue, and even worse, they don’t make that much money. Note the market cap of the company at a $6 stock price is about $1.25 billion. They got rightfully slammed after their third quarter report. It was awful.

Looking at their Q3-2022 report, the balance sheet has $58 million in cash and $808 million in debt. The only silver lining on the balance sheet is that the debt is in the form of a floating rate (LIBOR plus 275bps) secured loan that does not mature until October 2028, which is a huge time runway for them to figure things out.

The bad news is that the company is cash flow negative. Management talks about positive “adjusted EBITDA” this and that, but in reality, they are bleeding cash. They need to raise their prices and get their cost structure in line, especially now that LIBOR is rising like a piece of Styrofoam rising from the middle of the ocean.

I will spare the quantitative analysis other than to say that while the TTM price-to-sales is very roughly 2x (with companies such as TDY or FTV at 5x and 4x, respectively), the cash generation situation is just awful. This is not an attractive company using trailing financial metrics.

That said, it is in an industry which is relatively inelastic in terms of consumption preferences – companies that need the product are not going to suddenly defer their purchases. As a result, a general economic recession is not as likely to affect Mirion as it would for some other industrial suppliers.

The warrants

The warrants have a headline expiration date of October 20, 2026 and a strike price of $11.50. This is about 4 years to expiry. They are trading around 95 cents at the moment. I will humble-brag that my last purchased tranche to finish my trade was at 80 cents.

It might appear to be a bad deal considering the common stock is trading at half the price of the warrant strike price.

However, when it comes to warrants, they are not always traded like standardized options.

When reading the fine print of the Mirion Warrants, the most relevant non-standard clause governs the option of the company to exercise the warrants if the common stock trades above US$18/share, which will enable the holder to receive 0.361 shares of MIR at a 10 cent exercise price at expiration:

Mirion also has the right to exercise the warrants above US$10/share and the holders have a month to decide if they want the number of shares in the table or whether to take the warrants the ‘conventional’ way. I do not know any scenario where Mirion would want to force the conversion of warrants, but perhaps one of my readers can enlighten me.

Back to nuclear insurance

If there is a relevant nuclear event, I would anticipate the warrants would appreciate significantly beyond their current trading price. As there is time value remaining on these financial products, I would suspect in the worst case scenario in a couple years that I would be able to get out for moderate losses. Again, this is insurance more than anything else. And heaven forbid, if the company gets its cash flow situation in line and actually starts to learn to how to make profits, the stock will appreciate on its own.

This is a small position, I do not intend to make it larger, and the chance of making a loss is relatively high. I share this research for you.

Cenovus Energy Q3-2022 – quick briefing note

Cenovus (TSX: CVE) reported quarterly results.

The salient detail is that in addition to spending $2.6 billion in share buybacks and dividends, they are able to get net debt down from $9.6 to $5.3 billion for the 9 months. Specifically they have $8.8 billion in debt and $3.5 billion in cash.

They have a framework that gives off half the excess cash flow to buybacks and variable dividends. For Q3 this was allocated 75% to buybacks and 25% to the variable dividend.

In the conference call they alluded to this mix depending on the projected returns on the equity, which suggests a price sensitivity to their stock price.

This is exactly how they should be thinking. There should be a point where they stop buying back shares and instead just give it out in cash. At CAD$28/share, that point is getting pretty close.

They have a stated objective of dumping half their excess cash flow into their framework, and once net debt heads below $4 billion, then it becomes all of their excess cash flow. This should happen by the end of Q4.

While I believe a 100% allocation is not the wisest (they should top it out at 90% and focus on eliminating the debt entirely), given the maturity structure of their outstanding bonds, there is zero term risk in the next decade and a half (with their existing cash balances they can tender out the rest of their debt until 2037).

Once they start distributing 100% of their excess cash flow to dividends and buybacks, Cenovus will effectively function as an income trust of yester-year where you had Penn West and Pengrowth consistently giving out cash distributions. The buyback algorithm should auto-stabalize the stock price. At US$90 oil and refining margins sky-high and with little signs of abatement, Cenovus is on track to generating $8 billion in free cash flow for the year. Very roughly, that is about 14%/year and this is much higher than I can recall the historical income trusts yielding.

Unless if the stock price gets ridiculously high, or if management starts to display capital management that is off-colour (i.e. going on acquisition sprees that do not make sense), this is going to be a core holding for a very long time. It is too expensive to buy and too cheap to sell, so I look forward to collecting the cash distributions where I will try to find a better home for.

Bank of Canada will lose money for the foreseeable future

It is ironic that one victim of higher interest rates is the Bank of Canada itself.

After engaging in a massive amount of quantitative easing, as of October 26, the Bank still has about $400 billion of government bonds on their books. They collect interest income from these bonds as payments are made (a journal entry from the Government of Canada to the Bank of Canada). You can view the holdings and come to a calculation of approximately $5.9 billion a year in interest income that the Bank will earn from their “investments”. The Bank stopped publishing exact details of their $11.8 billion provincial debt holdings in 2021, but if we just model it at 25bps higher than the federal government, we get another $200 million in interest income, for a total of $6.1 billion a year.

This modelling is not quite correct – the above calculations used strictly the coupon rate for the government debt securities, and not the more appropriate measure of using the market yield to maturity as the basis for the revenues earned for government debt. Using this metric, the calculation bears less revenues – the 2nd quarter report of the Bank of Canada indicated $1.163 billion in interest revenues, which equates to about $4.65 billion annually. The $6.1 billion estimate above is too generous.

Pay attention to a typical interest rate announcement. The first paragraph is the following:

The Bank of Canada today increased its target for the overnight rate to 3¾%, with the Bank Rate at 4% and the deposit rate at 3¾%. The Bank is also continuing its policy of quantitative tightening.

If you are a member bank and wanted to borrow money from the Bank of Canada for a day, you would pay the Bank Rate. Conversely, the Deposit Rate is the money the Bank of Canada gives you for parking your money in reserves.

However, in our world of quantitative easing, a significant portion of the government debt purchased by the Bank of Canada got converted into two primary liabilities – the Government of Canada account, and the reserves of member banks (“Members of Payments Canada”).

When QE was going on, these liabilities resulted in insignificant payments – the deposit rate was 0.25%. However, interest rate increases have significantly increased the deposit rate to the 3.75% we see today.

As of October 26, 2022, the Bank of Canada held $282 billion in reserves held by banks and the Government of Canada. With the deposit rate now at 3.75%, the Bank of Canada now has to pay off $10.6 billion and this only offset by roughly the $4.6 billion a year received from the Bank of Canada’s bond portfolio on an annualized basis (and subtracting amounts that get quantitative tightened over time). The Bank of Canada also has an operating budget (to pay for staff, office space, IT, etc.) which annualized, is around $720 million.

My quick paper napkin calculation suggests that at a 375bps rate, the Bank of Canada will be losing around $1.6 billion quarterly as long as they have the roughly $282 billion in deposits on their books (currently $96 billion held in the Government of Canada’s name, and $186 billion held in member bank reserves). If the Bank of Canada stops paying the Government of Canada, this number goes to about a $3 billion a year loss. This number gets reduced in 2023 if the Bank of Canada continues its QT program, but such stemming of losses would be potentially offset by further interest rate increases. The number only swings back to profit when the Bank has eliminated the reserves on its liability book, or if it chooses to decrease the deposit rate.

Section 27 of the Bank of Canada Act is the mechanism where the Bank will remit proceeds over a certain amount to the Government of Canada – essentially sending its profits to the government. The legislation does not work in the other direction – it is implied that the Bank of Canada will always be making money! Some minutiae of the Bank of Canada states the following:

At 31 December 1955, the statutory reserve had reached the maximum permitted under the Bank of Canada Act of five times the paid-up capital. Since then, all of the net revenue has been remitted to the Receiver General for Canada. Following an amendment to section 27.1 of the Bank of Canada Act, the special reserve was created in 2007 to offset potential unrealized valuation losses due to changes in the fair value of the Bank’s investment portfolio. An initial amount of $100 million was established at that time, and the reserve is subject to a ceiling of $400 million. Effective 1 January 2010, based on an agreement with the Minister of Finance, the Bank will deduct from its remittances an amount equal to unrealized losses on available-for-sale assets. Prior to 25 March 2020, this category includes Other deposits.

The government has generously allowed the Bank of Canada to deduct its losses from the 2008-2009 economic crisis, which was not really needed because the Bank did not engage in wholesale QE during that era (less than $40 billion of reverse repurchases, which is a drop in the bucket compared to the numbers we see today – and they were settled in 2010).

However, this time is different, and the Bank of Canada will be facing significant losses as long as interest rates continue to remain at elevated levels. Their Q3 report will show a loss, and their Q4 report will show a big loss. It will blow through the $400 million reserve in short order.

I can imagine the upcoming hilarity that is going to occur on November 3, when the government announces the fiscal update which will likely include more “anti-inflationary (deficit) spending”. Part of this hilarity involves the government having to draft legislation to permit the Bank of Canada to incur losses and beg for money to keep operating. Just imagine the political backlash when Canadians learn that the Bank of Canada will be one more fiscal lead anchor that the public has to subsidize and also the sight of Tiff Macklem going to Finance and begging for money from the government to maintain the payroll.

Canadian Monetary Policy – Interest rates will continue to rise

Back on October 7, I wrote the following:

Until things blow up, my nominal trajectory for Canadian short-term interest rates will be:

October 26, 2022 – +0.50% to 3.75% (prime = 5.95%)
December 7, 2022 – +0.25% to 4.00% (prime = 6.2%)
January 25, 2023 – +0.25% to 4.25% (prime = 6.45%)
March 8, 2023 – +0.25% to 4.50% (prime = 6.7% – think about these variable rate mortgage holders!)

Note that the Bankers’ Acceptance futures diverge from this forecast – they expect rate hikes to stop in December.

We might see the Canadian 10-year yield get up to 375bps or so before this all ends, coupled with the Canadian dollar heading to the upper 60’s.

This October 26 prediction was a non-consensus call, with the markets generally pricing in a 75bps increase and me sticking my neck out with 50bps. I nailed it.

The 10-year government bond yield did eclipse 3.75% on October 21, but I am not claiming victory here – the intention of my post is that it will be occurring later in the future when it dawns into the market that short term rates are not dropping.

The Canadian dollar clearly hasn’t gone into the 60’s yet, but it should happen.

I get the general sense that the market is pricing in a change in the second derivative of the interest rate trajectory. The pattern looks very elegant – 25bps, 50bps, 50bps, 100bps, 75bps and now 50bps, and they expect another 25bps in December and then it’s done. Since the light can be seen at the end of the tunnel, party on, start playing the low interest rate trade since surely the Bank of Canada and Federal Reserve is going to loosen policy again and send everything skyrocketing.

It will not be this simple. Long term bond yields will rise and markets will fall when they come to the realization that inflation has not subsided.

Recall that inflation is not increased prices, but rather the expansion of money supply against a fixed amount of goods and services. Increased prices are a consequence of inflation.

The reason is that this assumption that market participants believe that central banks will come to the rescue in the event the economy tanks is what is causing the rates to continue increasing. It will only be when people are begging and pleading for relief that the central banks will relent, and likely bail out the entire populace with the introduction of a centrally administered digital currency.

The key metric to watch out for is employment. Although full employment is the mandate of the US Federal Reserve, it is something that the Bank of Canada will be paying attention to, albeit a lagging indicator.

We need to see unemployment rates climb before the psychology of inflation gets stabbed in the chest.

Until then, every item purchased at Costco and Walmart, every restaurant meal, every hotel and airline ticket, represents an element of aggregate demand which the supply is clearly still not expanding to.

There are signs that the tightening monetary environment is having an effect. Monetary aggregates have barely budged over the past year (M2++ is up 1.4% from January 1 to August 1 this year when the typical trendline is around 5%). But we are in a waiting period where corporations and individuals need to burn off their reserves before engaging in the real difficulty of belt-tightening that comes after some very poor fiscal and monetary decision-making.

Using a physical analogy, we have been eating daily at a buffet for the past two weeks and the 10 pounds of excess weight that we have gleefully put into our stomachs need to get worked off. Although the food has been taken away relatively quickly (rising interest rates), the fat on the waist is still showing (we still have a huge surplus of liquidity from the 2020-2021 fiscal/monetary actions).

Until we see signs of unemployment and, in general, “pain”, interest rates will slowly climb until we see people lose jobs. The Bank of Canada governor is slowing things down for political reasons more than anything else – he doesn’t want to be seen as the guy crashing the economy – and you can be sure that politicians of every political stripe, whether red, blue, orange, light blue or green, will be sharpening their knives and polishing their talking points.

Can Teck unload their met coal operation?

Teck (TSX: TECK.A/B) had some interesting news yesterday – they dumped their 21% interest in the Fort Hills oil sands project for $1 billion to Suncor (the majority owner and operator), and they also released their quarterly report.

The Fort Hills project was the black sheep of Teck, primarily because it goes against their “wokeist” image they are trying to project and is clearly not in their strategic mandate to be a lead producer of “low carbon metals” (aren’t all metals non-carbon?). Once the Frontier Oil Sands project was shelved, pretty much the days were numbered for the Fort Hills division.

For Q3, Teck’s share of the project was 37,736 barrels of oil a day, and the consolidated project is 180,000 barrels – not a trivial size.

The project historically has been plagued by operational issues and, in my quick evaluation, the deal is good for both Teck (who wanted to get out) and Suncor (who is likely to consolidate 100% of the project in the near future). The Frontier project might get revived in a future decade when regulatory concerns get alleviated, but I would not hold your breath.

Of note is that both companies (Teck and Suncor) will be taking non-cash accounting losses on the disposition – in Teck’s case, the amount of capital dumped onto the project is less than the amount that they were able to get back from it with this disposition. The impairment charge on the books was $952 million. The conference call transcript indicated there was a ‘small capital loss’ on the transaction.

Teck’s major project in the works is the QB2 copper mine in Chile. One reason why their stock had a tepid response to the quarterly report is because of the usual announcements of delays and construction cost escalation, coupled with a decreased expectation for production in 2023. However, this is yet another sign that one cannot click a few buttons on Amazon and expect a mine to start producing – the scale and scope of these projects is gigantic and this one has taken about 5 years to get going from the “go-ahead” decision to when things will be materially completed. If this decision was pursued today, the costs would likely be even higher (not to mention the regulatory climate would be even worse than it is today).

QB2 is the example of their “low carbon metals” strategy, where apparently they can be dug up from the ground without emitting carbon, but I digress. The “to-go” capital expenditure on QB2 is anticipated to be US$1.5-$1.9 billion from October 1, and once this is completed, Teck will be a free cash flow machine barring some sort of total collapse in the copper market (beyond the 30% drop from half a year ago).

The balance sheet is very well positioned, with $2.6 billion in cash and no major debt maturities until 2030 other than a US$108 million bond due February 2023, which they can easily pay off. As a result, Teck will be in a position to either buy back stock or issue increased dividends later in 2023.

But the focus of this post isn’t about QB2 or Teck’s future prospects, it is about their metallurgical coal operation.

Their met coal operation generated $1.24 billion in gross profits in Q3, and $5.55 billion year-to-date. It is single-handedly the reason why Teck is in such a fortunate financial position to be able to dither on QB2 and not get terribly concerned about it.

However, it flies in the face of their “low carbon metals” strategy and this reminds me of last year’s article which rumoured that Teck was looking at getting rid of, or spinning off their met coal operation.

My question is still the same – who would buy this? It is making so much money that even if you paid 2x annualized gross profits (an incredibly generous low multiple), somebody would still need to cough up $15 billion to buy the operation. This puts pretty much every coal operator out there except for the super-majors (like Glencore) out of the picture.

However, if Teck were to dispose of the coal unit, it would likely be in conjunction with a significant distribution to shareholders – a $15 billion sale would result in roughly a $22/share distribution, assuming a 25% tax rate (the actual tax paid will likely be less since Teck’s cost basis will be considerably higher from the Fording Coal acquisition). At a zero-tax rate, that would be roughly $29/share.

However, a giveaway is the non-answer during the conference call:

Orest Wowkodaw
Analyst, Scotia Capital, Inc.
Hi. Thank you. Jonathan, your number two priority seems to be rebalancing the portfolio to low carbon metals. I’m wondering if that if your strategy there is solely around growing the copper business and i.e. diluting the coal business, or do you see the potential for accelerating that transformation perhaps by either divesting some of the coal business?

Jonathan Price
Chief Executive Officer & Director, Teck Resources Limited
Yeah. Hi, Orest, and thanks for the question. There’s a number of approaches that we’ve been taking to that. The first as you’ve seen overnight is the announced divestments of Fort Hills. Clearly oil sands carbon, an opportunity there to reduce weight in the portfolio through that divestment, something we’re very pleased to have agreed and have gotten away.

Secondly, as you highlight really the key approach for us is the growth around copper with the doubling of copper production as we bring QB2 online next year. And then with the projects I mentioned being new range being San Nicolás being the QB mill expansion all bring more copper units into the portfolio which further swing us towards green metals and away from carbon. As we’ve said before, we’ll always remain very active and thoughtful in reviewing the shape of the portfolio and the composition of our portfolio. But right now those factors I’ve mentioned are the key execution priorities and that’s what the team is focused on. And that’s what we’re gearing up to deliver.

I’m pretty sure reading between the lines that they are, at the minimum, thinking of doing this. But who in their right mind would buy such an operation in a very hostile jurisdiction?