Very scattered thoughts

Just doing some general review and scribbling down some thoughts.

One is that the S&P 500 and TSX are up 25% and 23% year to date:

This is likely induced by monetary policy, with the US and Bank of Canada historically demonstrating a huge amount of QE:

The central banks have signaled that this party is slowing down.

Picture the flow of a notional dollar of capital from monetary policy.

Monetary policy has the Bank of Canada purchase a bond from a primary dealer (one of the big banks). The result is a BoC asset (government debt), and liability (reserves due to the bank). The big bank receives reserves as a credit at the Bank of Canada, which they can use to make loans. Customer X goes to the big bank and sees something that warrants taking out a loan. Big bank lends a couple dollars to Customer X (loan is the bank’s asset, Customer X has cash, at the cost of a yearly cash flow from customer (debit interest expense, credit cash) and to the bank (debit cash, credit interest revenue). QE makes it “possible” for the big bank to execute on this loan as they can do so more cheaply than if QE wasn’t in place, effectively making credit ‘cheaper’ and thus lowering the rate of interest.

In this scenario, the bank is the one suffering the default risk, and this dollar given to Customer X is not given to him by the central bank, so it is not money printing. The loan must be paid back, with interest.

Customer X takes the loan, and invests it in some widget machine with Company Y. Company Y takes the money to pay labour and materials needed to make the widget machine. The labour tends to spend it on various necessities (food, housing, consumer goods, etc), while the materials provider has to spend it on their payroll (labour) and capital equipment from Company Z, A, B, etc.

All of this is illustrating the flow of where the notional dollar of capital is generated and circulated – originating from a financial institution (the point of money creation) and circulating in the economy. Eventually profits from companies Z, A, B, etc., circulate into shareholder hands, and for the very rich that have nothing else better to do with capital (there is only so much food and drink and housing one can buy), gets slammed back into the equity market.

Clearly there is a point where you can just bypass all of this widget creation and just invest loaned capital into the equity markets directly, which seems to be the result of what has happened. The notional dollar does not get created or destroyed, but the path of where it flows is quite relevant. Depending on the speed it flows (monetary velocity) and where it flows, the economic outcomes wildly vary.

For instance, imagine a world where 99.9% of the cash is held in the hands of day-traders only, circulating amongst them within the Nasdaq and NYSE, and these participants have no interest at all in building widget machines. We seem to be increasingly in an environment where a lot of this capital is held in the financial and not real world.

When money bubbles out of the financial world into the real world, this is when we start seeing a chase up the prices for real assets. For instance, going back to our fictional world where day traders own 99.9% of the financial capital, they might discover that they need to eat food. But since the food markets have been so malnourished, all the day traders can do is just keep bidding up the few morsels of food remaining, until prices reach some absurd high – a typical hyper-inflationary scenario. Indeed, if the day-traders have to eat 100 units of food, and only 70 units of food are available, there is no amount of financial capital available that can satisfy the demand.

One can imagine that the high amount of financial capital available would dramatically increase the volatility for real goods and services when the carriers of financial capital recognize an imminent need.

Interest rates – watch out

The Bank of Canada yesterday had a more interesting than usual rate announcement:

The Bank is ending quantitative easing (QE) and moving into the reinvestment phase, during which it will purchase Government of Canada bonds solely to replace maturing bonds.

The headline is “ends quantitative easing”, but in reality, this is a reduction from $2 billion per week to $1.3 billion per week, which is enough to keep its $425 billion load of government treasury bonds level (the average duration of the Bank of Canada’s portfolio is 6.2 years, with most of it front-loaded in the first five years).

The picture painted (in the Monetary Policy Report) is projecting a restoration in the next couple years, but I believe such forecasts are going to prove misguided in that they are too optimistic. I do not want to provide much evidence to this claim here, however.

The Bank of Canada is trying to slow down the liquidity party without crashing the asset markets. This is going to be very interesting. In Canada, the big number to watch out for are the reserve levels of the banks that the BoC has bought the government debt from – this is the feedstock for the creation of currency, and there is still a lot left in there.

If history is true to form, things will appear to proceed until monetary conditions start choking and that’s when you’ll see the onset of further monetary policy induced volatility (which will then trigger another round of QE). We’re a bit of a ways from this point, however. The BAX futures are predicting quite a few interest rate hikes by the end of 2022.

A word of caution – any of your investments relying on this excess liquidity, be very careful.

Q4 IPO – typical SaaS issue

This analysis is not too deep, but I note that the IPO of Q4 Inc. (TSX: QFOR) had a tepid reception by the market – the IPO price was CAD$12 and the stock traded mildly under this after opening.

Q4’s primary function is to provide an investor relations portal for companies. It’s a distinct market and from what I can tell, the software does add value by offloading various functions that corporate secretaries would have to handle themselves (such as virtual AGM processing).

From the prospectus, we have:

As at June 30, 2021, approximately 50% of the companies that comprise the Standard and Poor’s 500 Index (“S&P 500”), 63% of the companies that comprise the Dow Jones Industrial Average (“DOW30”) and 48% of the companies that comprise the Russell 1000 Index (“Russell 1000”) are Q4 customers, and these numbers and their associated revenues continue to grow quickly

This is a reasonable sample – half of the Russell 1000 use this software.

Indeed, on June 30, 2021, there were 2,505 customers of this software. For the first half of the year, the average revenue per account was US$18k.

The IPO valuation is CAD$510 million on a fully diluted basis. The balance sheet is relatively clean, and they’re looking to raise CAD$100 million for the next ramp-up. The reason for this is despite them obtaining a credible variety of customers, they still have not been profitable.

This is a pretty good example in my books as a software-as-a-service that is scale limited and does not deserve a typical SaaS valuation.

There are two general issues here. Scale and competition.

On scale, how many publicly traded companies are there in North America?

The TSX and TSXV combined have about 3,300 listed companies. The NYSE has 2,300, Nasdaq about 3,700. Then the next tier, CSE is about 720, and OTCBB/Pink Sheets (which also covers international tiers and is quite redundant). I’m ignoring international (a logical audience would also be Australian and UK companies). Let’s ignore OTCBB and international for now and just focus on the first few – we have 10,000 listed companies as the target market.

They’ve already penetrated a quarter of this market. On a logistic curve, they are probably well past the half-way point on the y-axis in growth.

However, let’s say they manage to obtain 100% of their potential client base (a huge and unrealistic and wildly optimistic assumption). That’s a US$180 million revenue stream, a good chunk of money. But that’s the best case scenario short of offering parallel software packages to boost per-customer revenues.

The SG&A and marketing expenses of a software provider are not to be underestimated, let alone R&D expenses. They are material. One would think they will scale down, but it never quite ends up working that way.

Finally, there is competition – the cost of a company to switch to another provider. In the IR space, one would surmise it would be easier to transition than some other mission-critical software applications where discontinuity means death to a business. For US$18k/package, it is a trivial expense for many corporations. This works in favour of Q4, but as they try to raise the per-customer spend, it will most definitely attract competition of some type.

For these simple reasons, Q4 is a company I am not too interested in at this valuation. They have a good niche, but just because your company is in the SaaS domain does not mean you deserve Constellation Software valuations (currently 8 times sales). Good on Q4, however, for raising CAD$100 million. I think they hit the market at precisely the right time.

Arch Coal’s Q3-2021

ARCH is clearly a type of company where the analysts have most of the information well before the retail investor, which makes short-term trading of it a money-losing venture. You can see this in today’s trading action where pretty much most of the professionals got it right.

There is value, however, in making medium-range outcomes, where the playing field is a lot more level.

This is where it gets interesting today, specifically the question of how long this party in coal will last.

Putting a long story short, the demand for steel has increased since 2020’s Covid hit, while global supply of metallurgical coal has decreased. This is causing the current situation where steelmakers are forced to pay up.

Upon review of ARCH’s Q3-2021 conference call today, we have a company that is working like mad to sell both met and thermal coal. Indeed, they have pre-sold most of their 2022 thermal production at Powder River Basin at a margin that will likely net them about $10/share alone. On the met coal side, they are looking at spot seaborne prices of US$390/ton, and they have already been making sales for next year domestically in the US$200s, plus the added 3 million tonnes that gets produced in the Leer South project.

The majority of 2022 looks locked and loaded and will be incredibly profitable. It’s going to be, conservatively, about $600 million in free cash, probably more. Most of the capital expenditures will taper in 2022 as the last major construction project (Leer South) is done, and will clock around $125-150 million for the entity.

Mentally, this 2022 incoming cash flow can already be subtracted from the valuation as this is a known quantity. Factoring in Q4-2021, you can subtract about $50 of so off the stock price for the rest of 2022. The number might be even more, depending on how much high-priced met sales they can get off.

The question and value that an investor can bring to this point is what the heck is going to happen in 2023 and beyond (they’re already trying to sell 2023 production).

Right now, the stock is trading at a Price/2022 FCF of a low single digit multiple, perhaps around 2 and a half. Your valuation exercise, and what the sharps with the real information do not have, is what economic conditions are going to exist a year from now?

If things continue as-is, ARCH continues to be a dramatically undervalued stock – for each and every year these conditions are expected to continue, you can pack on another $50 or so to the stock price beyond what you currently see.

If you expect a crash in coal pricing (e.g. other international jurisdictions get their act together to ramp up supply, or steelmaking crashes), then you’ll take a hit. Depending on how bad it is, you could see a quarter of your investment evaporate.

Your typical spreadsheet analyst probably loves technology companies because their revenue curves fit really well to models. Earnings are predictable, and everybody is happy. However, the real value in investing is made in very jagged situations like this one.

Management is taking a very cautious approach with capital allocation. Their first priority is to pay down as much debt as possible (which they will be able to do in 2022) and then pre-pay some asset retirement obligations with the thermal business. They should be able to do both in the first half of 2022. They instituted a nominal dividend (25 cents/share/quarter) which will get some income ETFs in the mix, and then sometime in 2022, if the stock is still at their current levels and the commodity is still at highly profitable levels, will probably institute a buyback, although at a lesser scale than the overkill they engaged in 2019. I would expect the dividend to also increase in 2022.

Considering that costs on their met coal side is around US$60/ton and the commodity price is well into the triple digits, there would have to be a considerable crash before that business reverts back into a breakeven mode. It’s a pretty big cushion, albeit the coal market at this moment must feel like the conditions that traders of GME were facing at the end of January this year.

I think once the coal tourists get shaken off with the existing volatility and relative price disappointment (“Why isn’t this thing trading higher than 2 times earnings???”), the stock heads higher. The tough part, however, will be the day where you sell it at 4 times. Not today.

What do you do if you’re a steelmaker?

Steel factories at this moment must be facing a huge dilemma.

When your industrial process involves millions of tons of materials, you can’t exactly click a button on Amazon to get your feedstock – you need to order your inputs months in advance, if not years through a long-term supply contract.

So when prices are sky-high for metallurgical coal as they are, do you continue waiting and increase the risk that you will get no supply, or do you bite the bullet and secure a contract today?

At high prices, you are very unlikely to procure a long-term contract (who wants to lock in record-high prices on the buy side?). But you run the risk of not being able to properly price out your raw product to your own customers. It is a terrible situation.

We have a Q1-2022 pricing article that has the following:

US coal mining firm Arch Resources is offering a January-loading Panamax cargo of Leer high-volatile A coal at $410/t fob US east coast, with expectations of securing at least $400/t fob. The Leer high-volatile A coal continues to command a premium in the market, being particularly well-established in the Chinese market. “We are having trading firms chasing us pretty hard for high-volatile A coal into China,” said another US mining firm that said a European buyer was seeking 30,000t of high-volatile A coal last week. “We would be pushing for above $400/t fob ourselves.”

(fob US east coast, for those unfamiliar with shipping, means that once the coal is loaded on the east coast ship, the buyer pays and it is the buyer’s risk in the event of any catastrophe).

US$400/ton is a lot of profit, especially on a company with a US$50-60/ton cost structure. How long will this party last? Will any producers be able to supply long-term contracts at these prices, or will demand for steel plummet?