January 16, 2010

A Bid for Illiquidity

Back in November 2008 to January 2009 buying decisions were fairly easy. There was all kinds of opportunities to choose from. All you had to do was step up to the plate in any asset class or in any market and take a pitch. Right now buying any asset is not so easy. Credit and equities are fairly valued. I have not find anything of interest. I spoke about few ideas but nothing interesting materialized.

To find a good pitch I have to find a market where the level of professional analysis is a bit lower. So I will have to avoid the US markets. That means I have to find illiquid assets. That is fine by me. Liquidity is not worth a cent in my book. So I found the Canadian Debentures. Those are subordinated and unsecured, in some cases, debt instruments issued by companies of lower credit quality. I have sifted through dozens of these names and I have found two ideas. I tried to establish a position in both but I was unsuccessful and the price ran to the point it is no longer attractive to me, and that is why I am writing about them now.

Royal Host 2013 6.25% Debenture (RYL.DB.C)
Royal Host is a hotel owner and operator in Canada. It owns and operates economy hotels mainly in Ontario and Western Canada. I do not need to go into the hotel industry fundamentals as they are atrocious right now. It is worth noting that hotels performance is tied closely to the economy. But this is not a bet on the economy, it is a wager that I will get paid in 2013 at 100 cents on the dollar while purchasing the debenture at 68 cents on the dollar.

I have been stalking this issue for awhile but the price ran from me from $68 to $80 at the close Friday. I am no longer interested at that price but if it dips down I will try again. What makes it worthy? The issue is distressed debt in the hotel industry, where debt is selling at 68 cents on the dollar. If hotel vacancy and rent per room are stable at current level which is bottom of the cycle then debt is over collateralized at cap rate up to 11.5%, extremely low valuation even in the hotel industry. The Company have several liquidity generation abilities and should fund its obligation and debt maturities with no issues. The debenture offers the potential to generate IRR of 27%.

If you bought the issue at 68, the company will have no problem repaying you at 100 cents on the dollar even if cash flow from operations after debt service is negative, according to my analysis and valuation. The company have several options to generate funds:mortgage assets that are free and clearsell a sizable marketable securities portfoliocut its dividends
The only issue here is the company stock buybacks. The company is using its available funds and selling its portfolio to buy back its shares. It had tendered for 26% of its shares in December and going back for more in Jan 2010. Why is the company doing this while it cash flow from operation can barely service its debt. The answer is it may be setting up for going private transaction.

The company is 25% owned by Clarke Inc and its board are mostly controlled by Clarke. After the tender Clarke ownership will jump to 37% and potentially more after the additional tender offers by the company. Clarke obviously wants to take private Royal Host with little cash outlay on its part, particularly that Clarke's balance sheet is in worse condition than Royal Host. If the privatization takes place sooner than maturity the debentures will be redeemed at 101 cents on the dollar. However if the tenders keep coming it will compromise the collateralizing of the debt.

Still at high 60s or low 70s I think the issue is worth the risk. But now I will bite my time until either it comes down in price or look back and see how pretty my spreadsheets look like.

Next post I will tackle the second idea.