Aimia – not at this time

It’s been quite some time (four years) since I’ve written about Aimia (TSX: AIM).

The corporation is much ‘cleaner’ than it was when they were operating Aeroplan and especially now that they’ve sold their last loyalty program (PLM) they are sitting on a bunch of cash and assets. The PLM sale netted about $537 million, and by virtue of significant operating and capital losses in the past, the tax hit on this transaction will be relatively low. They still have a tax shield going forward and one of their stated intentions is to use their newly found half-billion dollars for investments to chip away at their tax shield.

From the June 30, 2022 balance sheet, they have a bunch of investments in income-losing entities. It does not inspire much confidence about future speculations.

Writing off the entirety of their investment portfolio, this leaves them with about $550 million to play with on 92 million shares outstanding, or about $6/share. There is no material liabilities or debt on the sheets. However, they do have $236 million in perpetual preferred shares outstanding which sucks out nearly $13 million/year out of the company, plus an even nastier Part VI.1 tax for another $5.1 million (hint to Aimia management – you perhaps might wish to NCIB the preferred shares). The rate resets are due in March 2024 and 2025, which would be at rates significantly higher than what they are paying now.

We know through public filings that they bought back 7.13 million common shares for $31.45 million in July and August. In a few days we will know about their September buybacks. The ending balance for August would be 85 million shares outstanding and approximately $510 million cash on the balance sheet, minus whatever else they threw money at in the interim.

Practically speaking, Aimia is trading at a price that is close to its cash balance, and assuming the remainder of its investment portfolio is worthless.

You would think that they should be able to convert half a billion dollars into something that earns a positive return. The Divestor Oil and Gas Index would be one avenue.

I tend to shy away from these “sum of the parts” entities because the incentives are generally misaligned for minority shareholders to make a proper return. Aberdeen International (TSX: AAB) was a poster child for this.

Aimia is controlled by Mittleman Investment Management, although they do not own a dominating stake in the company (approximately 10 million shares held between the company and the two brothers). Since Aimia does not have a common stock dividend, returns would be through capital appreciation. This typically would be driven by a share buyback, but as clearly evidenced by July and August’s trading action, the market has been more than happy to part ways with its shares at an average of $4.41.

The preferred shares are also not trading at a level that I would consider sufficient compensation (roughly 7% current yields and illiquid) given the overall situation.

Given the stress we are seeing in the market, even if there was a dump of liquidity on Aimia, I would find it probable that there would be some other part of the market that has a viable operating entity to be trading at equally or better levels at such a time. The fixed income component of it, however, I will continue keeping on eye on.

Canadian REITs

Here is a quick snapshot of most of the major Canadian REITs today. Pay attention to the very right-hand column, which is the Year-to-date performance of their units.

I’ll note that they are all universally down for the year.

Considering that such entities are heavily leveraged with debt to maintain the financing of their property acquisitions, this is not surprising. They are recipients of a double-whammy – higher interest rates will decrease their reported asset values (as they get appraised, they will drop), while at the same time, floating-rate debt will cost more, and any fixed-rate debt that renews will incur a higher financing charge. There is also the problem of what happens if the asset collateral declines in value to the point where the company cannot renew the debt.

CapREIT (TSX: CAR.UN) is an interesting example. Looking at the June 30, 2022 snapshot:

* $260 million outstanding in floating rate bank loans
* They have $6.6 billion in mortgages payable, 99% of it at fixed rates. The average effective rate is 2.62%.

I’ll spare the agony of going through this in detail (page 45/46 of their MD&A) and just leave it here. Suffice to say, they’ve done a pretty good job insulating their interest rates for now. But they will have to renew these debts at higher rates, assuming the existing rate structure continues. A 1% rise in interest rates results in a $68 million increase in interest expense.

At the current financing arrangement, in the first half of the year CAR.UN made approximately $200 million in FFO, or about $400 million annualized. With 173 million units outstanding, this is $2.31/unit or a current price/FFO of 5.7%. Not a huge return over the risk-free rate.

Interest rates have risen from 0.25% to 3.25%, starting March 2, 2022. While it will not be an instantaneous increase in financing expenses for CAR.UN, it will continue to eat away at their bottom line, unless if they are able to raise rents to compensate.

In a country with one of the highest rent to income ratios for our urban centres, it will be very interesting to see how much higher rents can ratchet.

CAR.UN is nearly entirely residential. The same math works, albeit with different wrinkles, for the commercial, office and industrial REITs, the latter sector historically being in the highest amount of demand.

But as the strangle of higher interest rates persists, these REITs, all of which are very leveraged, will continue to see financing pressure, especially if they do not have the ability to raise rents to compensate.

One would wonder if we are entering into a bad recession how much demand there would be for things such as office space and how much pricing power there would be to open an office in an urban centre. This likely explains why office REITs like Dream Office (TSX: D.UN) have been massively hammered. I would suspect residential would do better than office REITs, but what happens to people when they are unemployed and can’t afford to live in the city? This probably explains our current government’s immigration policy, which is to bring in approximately 440,000 people a year for the next few years, most of which will come to the urban centres.

My other last comment is that I think the 32% drop in CAR.UN year-to-date is highly reflective of the overall state of the real marketplace in terms of residential real estate – just that in the land title markets, the bid/ask spread is so high for individual properties that this magnitude of price decrease has not registered yet. Sellers still want their November 2021 peak pricing, while buyers cannot raise their bids because they can’t get dirt cheap financing any longer.

Revisiting ARCH

ARCH has been up and down like a yo-yo for the past half-year, ranging from roughly its current lows of 115 to a high of about 170 per share.

They have been able to cash in significantly in the post-Covid metallurgical coal boom, which is also instigated by the lack of capital invested in the industry.

I’ve been revisiting the math with this company.

I made some significant projection errors with my previous April 26, 2022 post. I improperly accounted for the shares outstanding (16 million vs. 19.8 million actual) and also underestimated the cash collection cycle when it come to the Q2 dividend. I was off by a mile, estimating an $11.60 dividend when it was actually $6.00! In fairness to my projection, the company did earn about $25/share on my mistaken input of 16 million shares, but they allocated some excess dividend cash to asset retirement.

I’ve sharpened my pencils since then and hopefully will be a little more precise. While at times I can be a spreadsheet warrior and try to calculate numbers to the nearest decimal point, investment analysis is a really strange business where in most cases it is intellectually wasteful to try to be exactly correct, but optimally be mostly correct with your assumptions and directions. We will apply the same standards here.

Balance sheet-wise, ARCH ended Q2 with approximately $191 million net cash, not including the $100 million they stashed away for asset retirement obligations. This assumes the capped call transaction is cashed in, and the convertible debt is converted. This positive net cash value represents about 10% of the market cap of the company, although for the purposes of this analysis we will make a conservative assumption and ignore the net cash on the balance sheet.

We will use 19.8 million shares as the denominator, although it is quite possible ARCH did perform share buybacks in Q3.

The key statistic in Q2 was the average met coal sales price of US$286 per ton. They already have committed sales in North America for US$216, and seaborne for US$284. The rest is spot sales, which for most part should be at comparative prices.

I see that Australian coking coal futures are trading around US$264 spot and US$310 for Q1-2023 coal (quite the contango).

The point is that Q3 met coal sales pricing should be around the ballpark as Q2, or about $400 million in net income.

This time, however, the company will have fully funded the reclamation funds and paid down the debt, so they can fully utilize the free cash flow for the 50/50 capital allocation model (half to dividends and the other half to either buybacks, capital preservation or the like). In Q2 the dividend was reduced by $40 million (~$2/share) than it otherwise should have been due to the $80 million contributed to asset retirement.

ARCH should be able to give off about $9/share in their Q3 dividend, based off of approximately $360 million in distributable cash. I am guessing that their accounts receivable balance will not bloat further during the quarter.

This will make the three-quarter average for dividends $7.75/share, or $31/share annualized.

Recall this is half of the company’s distributable cash flows, which annualized is about 27% of the current share price (US$115/share).

The company will probably dump the majority of the other half of free cash flow into share buybacks. Needless to say, at a price of a 27% implied yield and in a net cash situation, I do not disagree with using capital for buybacks. Even if they are the worst market timers on the planet, they would have bought back a million shares this quarter, which would take out 5% of the shares outstanding and they would be able to jack up the dividend even further – to about $9.50/share.

At US$280/ton for met coal prices, ARCH is a cash generating machine. The margin of safety is quite high.

However, many dead bodies are littered on the road of purchasing commodity stocks after cycle highs. If the world is heading into an interest rate induced global economic recession, it does not bode well for steel production, which in turn would sap demand for metallurgical coal production. Current indications suggest a mixed environment, which bodes well for future returns.

The only real threat, other than raw commodity pricing, is their tax shield. At the end of 2021, ARCH had reserved $500 million for a valuation allowance with respect to their income taxes. In the first half of 2022, they went through $120 million of this, which will result in their tax shield expiring around Q4-2023 at the current pace of their earnings. The blended tax rate for ARCH would be approximately 28% when this kicks in – reducing the returns significantly for 2024 and beyond, but still a very healthy amount.

How to survive a high interest rate environment

Things in the real economy are going to get a lot worse. You will see this with a lot of lagging indicators, especially unemployment. Come January and February 2023, the unemployment rate will rise a lot higher than the reported 5.4% for August.

The financial economy tries to predict these changes in advance and indeed, some of this has been already priced in. There are typically two areas where the market does not anticipate very well – when it over-extrapolates a trend, and also the failure to predict second and third order impacts of economic developments. The ability to predict these contributes to a lot of alpha for portfolio managers – worthy of a separate post.

At the end of the day, however, equity markets have some semblance of valuation on the basis of residual profits of the various entities which are given to shareholders. There is never an equilibrium price achieved, it is always fluid and subject to anticipation of changes.

When the so-called “risk-free” rate increases like it has, the comparisons become more competitive as there is always a risk premium between risk-free and risk-taking.

A concrete example of this is looking at a relatively stable equity versus a government bond.

We will use A&W Revenue Royalties Income Fund (TSX: AW.UN) as our example. It is nearly a universally recognized entity in Canada. The business is stable. The debt leverage employed is not ridiculous. While there are some complexities (the controlling interests have somewhat of a conflict with the unitholder trust), all you need to know for the purpose of this post is that the business skims 3% of the revenues of all A&W franchise sales across Canada. After interest expenses and taxes, the cash is passed to unitholders.

Right now this trust yields unitholders 5.4%.

Contrast that with a 1 year government bond, yielding about 4%, or a 10 year government bond yielding 3.1%. If you’re dealing with retail amounts of money and want to put it into a GIC, a 1-year GIC earns 4.53%, while a 5-year GIC earns a cool 5% – that’s a larger rate of interest than it has been for a very, very long time. Savers are finally getting rewarded for a change.

In contrast with units of A&W, you’re not receiving a lot of compensation for your risk. As a royalty business, you are less concerned about profitability and more about gross sales – your incentive is that the business operate rather than thrive. For some reason, the market warrants the risk spread (to government debt) of about 1.4 to 2.3%, depending on time horizon, is deemed to be sufficient. One can argue this is too high or too low, but right now it is what it is.

If interest rates continue to rise from here, it is only logical that the equity risk premium rise as well. In other words, if 1 year rates go to 5%, and 10 year rates go to 4.1%, then all things being equal, the equity should be priced around 6.4% – or the equity should take a 15% price haircut from the current point.

The equity risk taken is absurd especially in light of other perpetual investments that offer a seemingly higher margin of safety than A&W. An example would be in preferred shares of Pembina Pipeline, say PPL.PR.A, which gives you around a current 6.9% eligible dividend (much better tax treatment than royalty income) with a gigantic margin of safety. However, in rising rate environments, many of these entities are extremely leveraged with debt, which may result in credit risk deflating the value of your shares.

There is also the overall market liquidity risk – when liquidity continues to decline (central banks are tightening up the vice with QT as we speak), valuations across the entire market will compress as the marginal dollar does not have the ability to sustain high asset prices.

So how does one survive as an investor in a rising interest rate environment? There are very few escape valves.

One is cash, or very short-term cash equivalents. While you take the inflation hit, your principal will be safe. You will also be the recipient of rising rates when you rollover your debt investments into the like.

However, many do not have the luxury of holding cash (funds are restricted from holding over a certain amount).

Preferred shares in selected companies are another possible escape route. While they do not offer great returns, many of these firms that obviously will be solvent and paying entities are trading at reasonable yields. Your opportunity for capital appreciation is likely to be very limited, but at least you’ll be generating a positive and tax-advantaged return. (I will once again lament the upcoming redemption of Birchcliff Energy’s preferred shares (BIR.PR.C) as being the last redeemable preferred share left on the Canadian marketplace (R.I.P.).)

However, many do not have the luxury of holding fixed income products.

So say there is a gun pointed to your head and you are forced to wade into the equity markets.

The problem is that anything with a yield is sensitive to increasing interest rates. Companies trading at high multiples will have P/E compression and this will kill your equity value.

The formula is that you need to invest in a company generating cash at a very low multiple (well beyond a 2-3% spread from the risk-free rate), the cash flows are sustainable, AND the company can either repurchase its shares at such a low multiple or give out cash to shareholders at a yield well beyond the risk-free rate.

There are not many companies like this that trade. Ideally one day you would find a royalty company trading at a 15% yield. Then you would pounce on it with full force.

There are very few moments where you see this happen, and when it does, it can be very profitable. February 2009, Q1-2016, Christmas 2018, and March 2020 were some recent times where you had a gigantic rush for liquidity in various names.

Execution on the trading is also not easy – before a royalty company reaches a 15% yield, it will have to trade through 8%, 10%, 12%, etc. At these valuation points, it will increasingly look more and more attractive. Back during the economic crisis of 2008/2009, I remember purchasing long-dated corporate debt in Sprint (the telecom) for a 20% yield to maturity and feeling a bit resentful when at one point it was trading at 25% YTM before it slowly made its way back to the upper single digits YTM a couple years later. A similar situation with equities and some distressed debt will likely happen over the next 12 months, so plan accordingly to reduce resentment of not catching the absolute bottom – markets are most volatile at their bottoms and tops. I do not think we are at all close to seeing the peak in volatility for this cycle yet, which is surely a ‘down’ cycle.

Diversification

There are events that you just can’t predict, such as having to deal with malware on your web server.

This week has been full of them, and it is only Wednesday.

Teck (TSX: TECK.B) announced on the evening of September 20 that their Elkview coal plant (their major metallurgical coal operation) had a failure of their plant conveyor belt and it would be out of commission for one to two months. If out for two months, this would result in a loss of 1.5 million tonnes of coal. Considering that they can get around US$400/tonne for their product, and very generously they can mine it for US$100, this is a huge hit. Not helping is that one export terminal (Westshore (TSX: WTE)) is going on strike, but fortunately Teck managed to diversify from this operation last year with their own coal loading terminal!

Cenovus (TSX: CVE) owns 50% of a refinery in Toledo, Ohio. BP owns the other half, and they are the operating partner. There was a story how a fire at the plant resulted in the deaths of two workers, and the refinery has been shut down to investigate. Making this more complicated is that on August 8, 2022, Cenovus announced they will be acquiring the other 50% of the refinery for US$300 million in cash. Ironically in the release, it is stated “The Toledo Refinery recently completed a major, once in five years turnaround. Funded through the joint venture, the turnaround will improve operational reliability.”

Given the elevated level of crack spreads and the 150,000 barrel/day throughput of the refinery, the cost of this fire will not be trivial, and quite possibly will involve an adjustment to the closing price.

The point of these two stories is that there can be some one shot, company-specific event that can potentially affect your holdings – if there are other options in the sector you’re interested in investing in, definitely explore them and take appropriate action. Teck and Cenovus are very well diversified firms, but if you own an operation that has heavy reliance on a single asset (a good example would be when MEG Energy’s Christina Lake upgrade did not go as expected a few months ago), be really careful as to your concentration risk of such assets.

On a side note, have any of you noticed that many, many elevators are out of commission in publicly-accessible buildings? It’s like expertise in anything specialized is simply disappearing – it makes you wonder whether the maintenance operations of the above companies (and many others not listed in this post) are being run by inexperienced staff.